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Run, don't walk to sign up for your 401(k). Because of the exponential growth of compound interest, the best time to start saving for retirement is yesterday.

The 401(k): the Best and Easiest Way to Save for Retirement

Easier Said Than Done?

Easy StreetLast week I wrote that financial security is within your reach, particularly if you are young enough to benefit from the magic of compound interest. Just set aside your coffee money – about $100/month – in an investment account and watch it grow over the next 40 years. When you’re ready to retire, you’ll have several hundred thousand dollars without any additional planning or saving.

I acknowledged this could be easier said than done, as it’s hard to imagine giving up the simple (and relatively affordable) pleasure of a daily cup of coffee for a distant unknown future.

Ready to Invest?

I also failed to mention that not everyone is ready to invest at 20-something. For one thing, most investment advisors recommend saving at least six to nine months of living expenses as a cushion against unexpected job loss or other emergencies before investing.

Depending on your income, debt, and spending and savings habits, this could take a few years or more, which needn’t be a problem, because you still have the rest of your working life to save. But as we pointed out in our previous post, the later you start, the less time your money has to grow. A year or two won’t make a huge difference, but due to the exponential growth of compound interest, 10 years will.

If you start investing $100/month when you’re 25 years old, you’ll have a whopping $468,000 when you retire at 65. If you wait to till you’re 35 years old to start investing, you’ll “only” have $187,000.

Starting Your Retirement Account Now

If you’re not ready to invest on your own, but you’re eager to get a head start, you could be in luck, particularly if you work for a company that offers a 401(k) retirement plan. If your company doesn’t offer such a plan, you can set up your own Individual Retirement Account (IRA), which offers many of the same benefits.

Defined Contribution Plans

Both 401(k)s and traditional IRAs are “defined contribution” plans that offer tax-advantaged retirement savings. You contribute pre-tax dollars from every paycheck to your plan, which grows tax-free until you withdraw them at retirement age.

401(k): A Brief History

These days, few people, other than government workers, have “defined benefit” plans, which like the pensions of your grandparents’ era guarantee a regular retirement income. As these plans became increasingly more expensive to administer and fund, private businesses started switching to “defined contribution plans,” which employees fund with their own earnings.

Defined contribution plans were the brainchild of Ted Benna, an astute benefits consultant, who took a creative look at Section 401(k), an obscure 1-1/4 page section of the Internal Revenue Code, which allows delayed taxation on deferred compensation. Rather than pay taxes on your income when you earn it, you pay taxes when you take it home.

Though the tax code did not anticipate funding retirement plans with deferred income, Benna successfully appealed to the IRS, which modified Section 401(k) to allow exactly that.

In 1982, several large American companies offered the first 401(k) retirement plans. Participating employees designated a fixed contribution from their paychecks and and chose one of two investment options administered by a “plan provider.” Thanks to Section 401(k), these contributions were able to grow tax-free until they were withdrawn (and taken home) during retirement.

401(k) Benefits (?)

Needless to say, the popularity of these plans grew very quickly. While employees received a significant tax benefit, big companies quickly and drastically reduced their costs by ditching expensive pension plans.

On the positive side, small companies could afford to offer retirement plans for the first time, which helped level the playing field.

On the downside (perhaps), corporations shifted the responsibility and risk of retirement planning to their employees. In the new age of fund-your-own-retirement, participation is optional. (Today many employers offer automatic 401(k) enrollment, but employees can always opt out or reduce their contributions.) If you don’t participate – because your paycheck is already stretched too thin – you won’t reap the rewards.

When you do participate, your retirement is tied to the market. Unlike the old days, when government-guaranteed pensions made regular monthly payments for the rest of your life, the amount and duration of your payouts are determined by the market value of your account. When the market goes up, so do you. When it goes down, you do too.

The good news is that the market tracks up over time. The bad news is timing doesn’t always work in your favor.

Employer Matching Contributions

Many companies match employee 401(k) contributions to attract and retain good employees. Not only do they gain a competitive hiring advantage, they receive federal tax benefits when they make matching contributions.

If you’re fortunate enough to work for such a company, be sure to meet your employer’s match. If your employer matches your contribution up to six percent of your salary, you should contribute at least six percent. If not, you’re turning away free money.

How Does the Tax Benefit Work?

As we’ve already mentioned, your 401(k) contributions are tax-deferred, which means you do not pay taxes on them or their earnings until you withdraw them at retirement. This yields a threefold benefit as illustrated by the following example:

Let’s say you earn $50,000 this year and contribute $5,000 to your plan.

  1. When you file your tax return, you pay tax on only $45,000 ($50,000 minus $5,000).
  2. You contribute $5,000 pre-tax dollars (versus $3,700 after-tax dollars) to your retirement plan, which means your have a larger basis from which to grow.
  3. Because taxes are deferred, ALL your contributions and earnings continue to produce.

What’s an IRA?

If your employer does not offer a 401(k), 403(b) or 457, you can begin saving in a traditional or Roth IRA. But if you have access to an employer plan – especially if the employer offers matching contributions – that’s the best place to start.

Like a 401(k), an IRA offers tax-deferred growth on your investments, meaning the assets in the IRA will not be taxed until they are withdrawn. (Contributions to a traditional IRA may also be tax-deductible for people who don’t participate in an employer-sponsored plan.)

A Roth IRA offers opposite tax advantages. You pay tax on income before you contribute to the plan, but you pay no tax when you make withdrawals in retirement. 

Eligibility Requirements

While 401(k) participation is limited to people who work for companies that offer such plans, anyone under the age of 70-1/2 can contribute to a traditional IRA. Roth IRAs have qualifying income limits, though they are fairly high: $116,000 for individuals and $183,000 for married couples filing jointly.

Contribution Limits

In 2015, employees can contribute up to $18,000 of pre-tax income to a 401(k). Those over 50 can make an additional catch-up contribution of $6,000.

Contribution limits are much lower for IRA accounts. If you’re under 50 you can contribute up to $5,500/year to your IRA. If you’re over 50, you can contribute an additional $1,000.

Choosing the Right Plan

Though 401(k) plans and IRAs offer similar benefits, you should consider their differences before deciding on a plan. Keep in mind it’s possible to fund both.

The three main differences between plans are:

Tax Treatment

Traditional IRAs and 401(k)s are taxed the same. Your contributions grow tax-free until you withdraw them during retirement, at which time you pay taxes.

Contributions to Roth IRAs are made in after-tax dollars; however, they grow tax-free and you never pay taxes on the gain.

Possible Employer Contributions

Investment firms typically set up traditional and Roth IRAs for individuals. As there is no employer involvement, there is no opportunity for an employer match.

Investment Options

IRA account holders have greater investment freedom than 401(k) holders. Since they set up and control their own accounts, their investment choices are not limited to those provided by a plan provider.

Run, Don’t Walk to Meet with Your 401(k) Plan Administrator

BudgetingEven if you haven’t managed to set aside six to nine months of living expenses in your emergency fund, you can easily start saving and investing in your future through an employer-sponsored or individual retirement plan.

If a 401(k) plan is available through your employer, schedule an appointment to talk with the plan administrator. He or she will walk you through available investment options and help you evaluate which is best for you.

Also, click on the “Cool Tools” tab on here where you’ll find three very easy-to-use retirement calculators that will help you evaluate your contribution level.

401(k), A Mixed Verdict

If you’re young and invest early and often, your 401(k) or IRA may be enough to assure a financially secure future without any additional retirement planning or other investments. If you’re older or a less consistent saver, 401(k) savings may not be enough.

In spite of the 401(k)’s popularity – with an estimated $4.4 trillion in assets as of July 1, 2014 – about half of American workers still don’t have one. And most plans are underfunded. Today the typical middle-class household facing retirement has saved about $120,000, which is nowhere near enough.

This comes as no surprise to Ted Benna, the father of the 401(k), who never intended the plan to take care of all our retirement needs. Pressured by his corporate clients, which demanded bigger tax breaks and lower employee benefit costs, he effectively concocted a bribe for workers: they got extra money from the boss and a tax break, if they took some of their own paycheck and set it aside for retirement.

It worked – perhaps, some would argue, all too well. While it has helped millions of American families save for retirement, the law of unintended consequences may have harmed millions more as private sector employers swapped expensive pension plans for cheaper 401(k)s.

No matter which side of the argument you’re on, there is no question that Americans today are more on their own than any generation since WWII when it comes to planning and saving for their future.

Notes:

This example assumes an average annual rate of return of 9% on your investment. While 9% is high in this market, the S&P 500 has averaged 11.75% since its inception in 1975.

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About Steve Lome

Steve Lome and Dave Kramer are the guys behind “The $500 Cup of Coffee, a Lifestyle Approach to Financial Independence, Especially for Millennials and the People Who Love Them”.

We are not professional financial advisors, but we have lots of money experience.

As a mortgage broker, Dave reviewed the personal financial statements of thousands of customers. As a developer of affordable housing, Steve learned it was easier to build a house than a mortgage-ready customer, because so many of his prospects were wearing or driving their wealth. They both realized that no matter how little or how much people make, most do a lousy job of managing their personal finances.

Dave first conceived of “The $500 Cup of Coffee” as a way to help his clients save their money. Working with Steve, he re-imagined it as a roadmap to financial independence that almost anyone can follow. The final result is a well-balanced blend of Dave’s straight forward thinking and Steve’s expansive worldview that encourages a commonsense, relatively low pain approach to wealth accumulation, emphasizing conscious consumerism, steady saving and regular investing.

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