For most Americans, their 401k savings program at work is their single largest retirement asset.
According to a recent report from Transamerica, “Thirty-nine percent [of baby boomers] expect their primary source of retirement income to be self-funded from accounts such as 401(k)s, 403(b)s, and IRAs or other savings.”
The Pension Rights Center estimates that a full 65 percent of retirees will rely on assets for at least some of their retirement income.
But often we look at our statements and don’t know for sure what we are seeing. Here are few terms it might be good to understand:
Employee contribution. This is the money you choose to save out of your pay. This money is added to your 401(k) every time you get paid. This is also known as a “salary deferral.” You take some of the money you have earned today and defer it into the future for later use.
Employer contribution. This is the money that your employer adds to your account every payday. The number is often calculated through a matching formula based on the amount you choose to save. The more you save, the more the company matches, up to a point. This leads us to a couple of other terms directly related to employer contributions.
Matching formula. Thisis the formula used to calculate the match. A very common formula looks like this:
- Dollar-for-dollar match on the first 3 percent of your earnings that you save.
- 50-cents-on-the-dollar match for the next 2 percent of your earning that you save.
This means that if you save 3 percent of your earnings, that amount plus the matching money from the company will total 6 percent of your earnings sent to the 401(k). If you save 5 percent of your earnings, you will get that amount plus 4 percent of your earnings more from the company, for a total of 9 percent of your earnings added to the 401(k).
Vesting schedule.These are the rules that govern how much of the company contributions you own today. Some of the money is 100 percent vested the day it’s deposited into your account. Other money only becomes yours after you have been with the company for a number of years. A common schedule looks like this:
- Year one: 0 percent vested. At the end of they first year with the company, you own none of the matching money.
- Year two: 20 percent vested. At the end of two years of employment you own 20 percent of all the company matching contributions.
- Year three: 40 percent vested. At the end of year two you own 40 percent of the company contributions.
- Year four: 60 percent vested.
- Year five: 80 percent vested.
- Year six. 100 percent vested. So employees who have been with the company for at least six years own all the matching money in their 401(k).
Defined contribution. When you read a description in the HR benefits booklet that describes the company retirement plan as a Defined Contribution Plan, that means that the company is spelling out how much money it’s willing to add to your account. There is no assurance about what that money will grow to or how much income you could expect in retirement. That’s all up to you.
Roth 401(k). This is an option that’s available in most all 401(k) plans in the U.S. It gives the employee the option to save money into the 401(k) after tax. So how is that different from normal IRA?
- A traditional 401(k) savings contribution is pre-tax. This means that any money you save to the 401(k) reduces your taxable income today and goes into the account to grow for later. Whenever you remove it, all the money coming out is considered taxable income to you at that time. You put off paying income tax on this money until you consume it. The assumption is that you will be in a lower tax bracket 30 years from now when you are retired.
- A Roth 401(k) savings contributions is taxed now as part of your normal pay. You pay it through payroll deduction and you are done paying taxes on this money. The money grows in the 401(k) account and when you remove it, all the money is tax free. If you expect your tax rate to be the same, or higher during your retirement years, you will have more spendable money with a Roth 401(k).
Basis points. Theseare listed in the documents discussing your investment options inside the 401(k).
- First, you should know that a basis point is 1/100th of 1 percent. So 100 basis points (bps) equals 1 percent.
- Second, you should understand all the places that basis points are subtracted from your account. The disclosure documents spell this out, but they can be very confusing. Typical places you will pay a fee include:
- Investment management fees inside the investment fund
- Platform fees from the 401(k) recordkeeper based on your account value
- Advisory fees from the financial professional working with the plan. They are often a great resource and you are often paying for them whether you use them or not
Your personal financial planner can help you sort through your 401(k) fees.
How should I save for retirement?
I mentioned earlier that most of us are depending on the 401(k) account to be very important to the success of our retirement plan. But lots of us are not maximizing the value of these tools. By law every participant is allowed to add as much as $19,000 per year of their earnings to the 401(k). If you are better than 50 years old, you can add an additional $6,000 per year.
But a recent Vanguard study showed that only 13 percent of 401(k) participants maxed out their 401(k) in 2017. The data was compiled from an analysis of 1,900 401(k) plans with 4.6 million participants.
Why hire a CFP® ?
If you would like help sorting out where your 401(k) fits in your retirement plans and how you can make the most of this resource, you might want to talk with a CERTIFIED FINANCIAL PLANNER™ professional. The CFP® professional is well suited for this discussion since every CFP® professional is trained in multiple financial areas where a company retirement plan can be important. CFP® professionals are trained in:
- Budgeting and cash flow
- Risk protection and insurance
- Investment management
- Retirement income planning
- Estate planning
If you would like to talk to a CFP® professional in your area, I suggest you start with a search here. The link will let you see CFP® professionals near you.
As you are looking for a great advisor, I suggest a couple things to check:
- Is the advisor always the client’s advocate – a fiduciary advisor?
- Is the advisor only paid by clients, not any financial product manufacturer or distribution network? That would be a fee-only advisor.
These two points help assure that you are working with a professional who is committed to your best interest at all times. It seems obvious to me that a professional would work in this way, but it’s not automatic.
A fiduciary, fee-only CFP® professional can help you create a financial plan that is driven by your goals and priorities and addresses all aspects of your financial life. With a big-picture approach, you will be better prepared to understand your options at every step along the way.
Yes, I am a CFP® professional. I’m always a fiduciary and I only work on a fee basis. And yes, I’m still taking on a few great families to be part of my financial planning practice.
If this article has you thinking about your 401(k), contact my office at email@example.com. I am always happy to meet with people who are working on their retirement plans. Dunncreek Advisors does not provide legal or tax advice, nor is this article intended to do so.