Would you leave free money on the table?
Not a chance, if you’re like most people. But you might be doing exactly that with your 401(k). To follow up on our 401Kiki event, which benefited the Edie Windsor Coding Scholarship, we’ve put together this guide to all things 401(k).
Find out how much you can save in a 401(k), what kind of investments to keep in a 401(k), 401(k) alternatives for once you’ve hit your contribution limit (#retirementgoals) and, most importantly — why you should open a 401(k) account in the first place!
Why open a 401(k)?
You’ve probably heard that Social Security trust funds are running out of money. But you might not know how soon that could affect your life.
Unless something changes, Social Security will need to reduce the amount of benefits it pays as early as 2034, CNN reports. By the time you’re ready to retire, there might not be much left –– which is why it’s important to take charge of your own retirement savings.
If you work for an employer, that starts with the 401(k).
At Daylight, we consider retirement savings an LGBTQ issue. Hear us out: Wealth management firm UBS reports that LGBTQ people:
- Are less likely to have a will or estate plan (19% versus 26% of cishet peers).
- Put less of their paycheck toward retirement (20% versus 25% for cishet peers).
- Are less likely to have any money saved in a 401(k) (35% versus 40% for cishet peers).
There are lots of systemic reasons why queer folks are behind on retirement savings. But we didn’t come this far toward equality to not thrive during our golden years!
We can’t say it enough. To live your best life in retirement, you need to make saving a priority while you’re working. That’s where a 401(k) comes in.
So what is a 401(k), exactly? It’s an employer-sponsored retirement account that’s funded through contributions from your paycheck and, if you have this benefit, through employer contributions.
Your workplace might contribute a flat percentage of your pay across the board. Or it might offer a match percentage, where the company matches your retirement savings up to a set percentage point.
If you’re just getting started with a 401(k), setting aside 10% of your gross pay is a good goal. If you earn $60,000 a year, that would be $6,000. Assuming you’re paid twice a month, that breaks down as $500 a month. If your employer matches your contributions up to 5%, that’s an extra $3,000 in your account for the year.
How much can you save in a 401(k)?
The IRS sets an annual limit on 401(k) contributions because they have tax implications. For 2021, you can save up to $19,500 in a 401(k). If you’re over age 50 you can save an added $6,500.
It’s worth noting the tax implications of a 401(k). Your contributions are pre-tax. They don’t just sweeten your future, they lower your tax obligations now. You’ll have to pay taxes in retirement when you withdraw the money, but there’s a good chance it’ll be at a lower rate.
Choosing investments for your 401(k)
As part of your employee benefits package, you’ll receive a list of investments to choose from. These tend to be mutual funds, which are basically large baskets full of stocks and bonds.
Two types of mutual funds commonly offered in employer-sponsored retirement plans, including a 401(k), are index funds and target-date funds (a.k.a. target-date retirement funds).
- Index funds are mutual funds that track a stock index like the S&P 500. Investing in index funds gives you exposure to all the stocks that make up the S&P 500.
- Target-date retirement funds are set in increments that reflect a retirement year: 2050 for someone who will be 67 in 2050, for example. They start aggressive, taking on more risk to grow the balance quickly, assuming the market goes up. They become more conservative as the retirement year approaches to protect your savings against market downturns.
The right investment for you depends on your preference and risk tolerance. A target date retirement fund is ideal if you tend to be hands-off with investments. The money will most likely grow for you until you need it.
If you’re a cautious investor, a low-risk fund will preserve your savings –– but it may not grow very much. A high risk fund could bring big rewards, but you’ll have to stomach the volatility of big market swings.
You’ll find quizzes that assess your risk tolerance and suggest an appropriate asset mix for you — like this free investor questionnaire from discount brokerage Vanguard. This can help you narrow down the list of funds.
The most common 401(k) alternatives include:
- 403(b): 403(b) plans are essentially 401(k)s for nonprofits, public schools and a handful of other employers. Just like 401(k)s, these use pre-tax contributions and can include employer matches. The contribution limits are the same as for the 401(k).
- Traditional Individual Retirement Account (IRA): As you might be able to guess from the word “individual” in the name, this is a retirement account you fund and manage without going through an employer. In 2021, individuals can contribute $6,000 ($7,000 for 50+) to an IRA. Traditional IRA contributions are tax-deductible with a caveat: If you’re a high saver, you might not be able to deduct all your contributions to your IRA and 401(k).
- Roth IRA: Like the traditional IRA, this is self-funded. A Roth is taxed when you put the money in and not when you take it out. If you stash money away now, it’ll grow tax free until you need it. Roth IRAs are a way to boost your retirement savings and reduce tax liability later on, since you won’t owe tax on withdrawals. You can contribute up to $6,000 ($7,000 for 50+) to a Roth IRA as long as you earn less than the income threshold, which is $125,000 for single filers or $198,000 for married filing jointly. After that, the amount you can contribute decreases as your income increases.
- Roth 401(k): A Roth 401(k) combines the Roth tax treatment with the 401(k) retirement account. These less common employer-sponsored retirement accounts are taxed at contribution then grow tax-free. Contribution limits are the same as for a 401(k): $19,500 plus $6,500 in catch-up contributions for those 50+.
When to open an alternative retirement account
In our 401Kiki video, we covered some of the reasons you might choose another type of retirement account. To expand upon that here, let’s reiterate two things:
- Any amount of retirement savings is good! Seriously.
- If you have high-interest debt, like a credit card with 20%+ interest, pay that off before saving for retirement. There’s one exception: If you’re fortunate to have an employer match, you might want to direct enough money toward the 401(k) to get the match while paying off debt. Remember what we said about free money?
If you max out your 401(k) in a year and want to save more, you’ll need another type of account. That’s when you’d think about opening an IRA or Roth IRA. You might also open an IRA if you’d like wider options for investing, whether that’s individual stocks or investments that align with your values.
Experts generally advise that you contribute to a Roth IRA when your earnings and tax bracket are low. If you don’t make a lot of money, you don’t really need to shield your income from taxes.
When you’re in your prime earning years, you might move into a higher tax bracket. Directing more money toward a 401(k) or a traditional IRA actively reduces your tax obligations.
A financial planner can help you understand the nitty gritties of these accounts and advanced topics, like investment strategies.
Are you maximizing your savings?
For now, if you have access to a 401(k) at work, check your contribution limits. Are you saving as much as you’d like? Can you bump up your savings rate to take full advantage of an employer match?
Every dollar you save now helps secure your future. Thanks to the magic of compound interest, even a little amount in your 20s will really add up by the time you reach retirement age.
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