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What is a 401(k) plan and should you participate?

What is a 401(k) plan and should you participate?

Nicolle Willson, J.D., CFP®, C(k)P®

The global economy is having a big impact on small businesses across the country. To help small business owners and their employees stay informed during this challenging time, we’ve gathered information on 401(k) savings, investing, and more. For the latest news and insights, visit our resource hub.

This probably won’t come as a surprise, but Americans are lousy savers. A recent Guideline survey found that only 48% of workers feel at least somewhat confident about their ability to retire comfortably someday. And while more companies are offering retirement plans like a 401(k) as a benefit to their employees, a report from the Economic Policy Institute found that only half of American families have any retirement savings at all.

So should you participate in the plan you’ve been offered? What are the benefits? And how much should you be investing? If you’re one of the millions of people out there struggling to save, here’s a closer look at how to make smart decisions about saving for retirement.

What you should know before you start

Before you make any big decisions about how to build your nest egg, it’s important to consider a few key factors. We’ll run through them quickly, but if you want to get straight to the point, skip ahead: Should I contribute to my 401(k) plan?

Still with us? Here are the basics you should know:

What is a 401(k)?
A 401(k) is a retirement plan that many employers offer to help their employees save for retirement. The primary advantage of contributing to your 401(k) plan (instead of a normal investment account) is that the contributions you make are tax deferred. That means the money is taken directly from your paycheck before any income taxes are taken out of it, and it grows tax-free in your 401(k) plan.

You shouldn’t plan to withdraw funds from your 401(k) plan until you reach age 59 1/2. You can if you have to, but you’ll be forced to pay stiff penalties — or interest if you want to borrow against the value of your account. And you do eventually pay income taxes when you decide to withdraw funds from your 401(k). The tax benefit for most people comes because they are often taxed at a lower rate during retirement than they would have been when they made their 401(k) contributions. If everything else is equal, that means your nest egg will probably grow quite a bit bigger if you build it by investing in your 401(k) plan instead of a normal investment account.

A lot of workers like 401(k) plans because some of the setup is done for you and there aren’t as many tough decisions to make. If fact, over 60% of workers who aren’t offered a plan by their employer cite the ease of investing as their number one reason for wanting a plan. If your company already offers a plan through Guideline, here’s what it takes to get set up.

What is the difference between a traditional and Roth 401(k) account?
Traditional 401(k) retirement accounts allow individuals to set aside a share of their paycheck on a pre-tax basis. This means that the IRS can only tax these funds when the individual receives a distribution from the plan.

On the other hand, Roth 401(k) accounts allow employees to contribute on an after-tax basis. While that means you won’t be taxed on qualified withdrawals in the future, it also means your contributions will take a more substantial bite out of your paycheck today.

What are the limits for contributing to a 401(k) plan?
In 2022, employees can contribute up to $20,500 into a traditional or Roth 401(k) plan. Anyone age 50 or over has an additional $6,500 of catch-up contributions.

Does your company match your 401(k) plan contributions?
Some employers choose to match a portion of the funds their employees contribute to their 401(k) plans. If your employer matches your contributions, it means they’re essentially giving you free money when you participate in your 401(k) plan. According to our survey research, grabbing this free money is workers’ number one reason for participating in a plan. (For the record, reason number two is the ease of investing.)

More companies are offering employer matching, and that’s a good thing for everyone because it improves employee participation. And it’s especially good for you because it means you’ll be adding more money to the compound interest machine.

What’s compound interest, you ask? In the simplest terms, it’s the “interest on the interest” that your investments earn. For example, if you invest $100 and earn 10% annually, you would earn $10 in the first year. In Year 2, you also earn interest on the interest from Year 1, which means you’ll earn $11. And in Year 3, you’ll earn 10% on $121 (i.e., $12.10) and so on. Your $100 investment would double in around seven years if you were lucky enough to earn 10% annually.

Should I pay off existing debt first? This is probably one of the most crucial factors in your decision to sock money into a 401(k) plan. If you have a lot of household debt, then it’s likely that it’s accruing interest. If that debt is for your house, student loans, or your car, then the interest rate is probably pretty low — 5% or lower. However, if you have credit card debt or personal loans, the rates can be well above 15%.

Doing the math, taking advantage of an employer match can mean an instant return on your 401(k) investment. If your employer matches 50% of your contributions, that means an instant return of 50%. But people who carry high-interest debt often prefer to pay off their debt before they save, even when their company offers a match. Historically, a typical S&P 500 Index Fund has returned about 7% annually, so if the interest on your debt is higher than 7%, you could wind up paying more in interest than you’ll earn on your investments.

However you look at it, it’s a good idea to make sure you have a foreseeable path to paying off that high-interest debt before you commit too much to your 401(k) plan. If you can defer some of your salary into a 401(k), get matching funds, and still whittle away at the debt, it’ll be worth it. Again, the ability to save and pay off debt depends a great deal on the amount of debt you have, and your ability to live within your means.

Will you need liquidity in the near term? If you need your salary for household expenses or are saving to buy a car, a house or another big-ticket item in the next year to 18 months, you should weigh the decision to contribute to your 401(k) plan very carefully.

Money you put into your 401(k) plan should be left alone until you’re ready to retire. Yes, some plans allow you to borrow money from your account or take distributions early, but you will be subject to fees, penalties, taxes, and you’ll miss out on the compounding effects that time will have on your retirement balance.

It’s important to think about your retirement on a short-term and long-term basis. Don’t be so eager to save in the short-term that you wind up putting yourself in a bind. Similarly, many financial planners recommend having an emergency fund with enough cash to cover expenses for a few months. It’s a good idea to make sure you have what you need to weather any short-term financial storms.

How to prioritize your 401(k) contributions

There are so many factors in personal finance that it’s hard to know where to start the decision-making process. We all have basic costs of living like rent or mortgage payments, bills, and transportation costs. And some of us have things like childcare expenses and medical bills.

But once all those basics are settled, where should saving money via a 401(k) be on your list of priorities? Keeping in mind the caveat that everyone’s personal finance situation is different, here’s a rough list to get you started:

Pay off high-interest debt: Nothing hangs financial dread over you like credit card balances and other high-interest debt. Get those balances paid off pronto, or, at the very least, consider consolidating credit debt to lower your rates and make sure you’re confident you’ll be able to pay down these debts before they balloon.

Build up an emergency fund: A recent Bankrate survey found that only 39% of Americans could pay for a $1,000 emergency with their savings. Most experts recommend stockpiling a minimum of three to nine months of expenses in your savings accounts for a rainy day.

Grab that employer match in your 401(k) plan: If your employer matches your contributions, take advantage of it as soon as you can. It’s not uncommon for some companies to match as much as 6% of your income, so the benefits of taking full advantage of matching can be huge.

Save for major purchases: If you’re saving for a down payment, a wedding, or some other major purchase, it often makes sense to prioritize it just below paying off high interest loans and taking advantage of the free money in your employer match.

Contribute to a Roth plan: If you’ve maxed out your employer match, but still want to tax-deferred savings, you should consider a Roth 401(k) plan or IRA next. A Roth is beneficial because you pay income taxes up front, but then its earnings are totally tax-free. If you wind up being in a higher tax bracket than you are now when you retire (which is probably the case if you’re just starting your career), then a Roth is more likely to be beneficial. If you think it’s more likely that you’ll be in a lower tax bracket when you take the distributions, however, a Roth may not be as advantageous.

Non-matched 401(k) or IRA contributions: If you’ve exhausted steps one through four, the next thing to consider is a Traditional 401(k) plan (sans match) or IRA. Even if your employer’s 401(k) plan doesn’t offer a match, you can still get a great tax benefit by deferring part of your pre-tax pay into investments that will grow over time. Never underestimate the power of compound interest! (Have we mentioned that yet?) Likewise, getting some money into a Traditional IRA will allow you to take a deduction on your tax return — up to $6,000, plus a $1,000 catch-up for taxpayers over 50 in 2020, but this option is not available if you contribute to your 401(k). The deadline for IRA contributions to qualify for a tax deduction on your 2019 return is April 15, 2020.

Pro tip: Make sure you understand the fees associated with your 401(k) plan. On their own, 401(k) plans have some great tax advantages, but many plans charge employees fees of over 1% per year, which can have a huge impact over time.
529 plans: If you have kids and want to save for their education, a 529 plan is a great way to accomplish that. Many states offer a deduction for contributions to a 529 plan, and the earnings and distributions are always tax-free if they are used for qualified education expenses for your child. And just like saving for a 401(k), compound interest does all the work for you in a 529 plan.

Other investments: If you’ve tapped out all the above, any extra funds can be stored in other investments like real estate, stocks, bonds, trusts, or other assets.

Lower interest loans: Finally, you can start chipping away at the principal on your low-interest loans. This borrowing is usually for automobiles, homes, or other long-lived assets.

Happy saving!

The fact that you’re thinking seriously about this stuff probably means you’re on a better path than most Americans. So should you participate in your employer’s 401(k) plan? If they offer to match contributions, then it’s an especially good opportunity to save. Just be sure you take into consideration your whole personal situation before you commit money to your 401(k). Make sure high-interest debt won’t be too much of a burden, and consider your short-term financial needs so that any surprises won’t undermine your long-term goals.

If you already have a Guideline 401(k), log in to review your plan and set a contribution level that makes sense for your financial situation. If you need help activating your account, click here.

The information provided herein is general in nature and is for informational purposes only. It should not be used as a substitute for specific tax, legal and/or financial advice that considers all relevant facts and circumstances.  You are advised to consult a qualified financial adviser or tax professional before relying on the information provided herein.