Written by: Corey Janoff
We write about a lot of high-level topics on this blog when it comes to saving for retirement. Today it’s time to go back to the fundamentals and make sure everyone understands the basics of workplace retirement plans.
Shout out to Justin Fukuhara for coming up with the idea for this week’s blog.
Save this post to your favorites to reference in the future. Send to your younger colleagues who may not have participated in a workplace retirement plan until now. Heck, send it to any students you know (med school, college, high school) so they can develop a base level of knowledge and know what to do when they start their first real job.
For simplicity, we’ll focus on 401k and 403b type accounts, since those are the most common workplace retirement plans, but much of what is discussed today will apply to other retirement accounts as well.
Why Participate in a Workplace Retirement Account?
First and foremost, you should participate in your workplace retirement plan so you can one day retire! If you want to eventually stop working, you need to save a portion of each paycheck and set it aside for your future.
Retirement planning made easy:— Corey Janoff, CFP ® (@CoreyJanoffCFP) August 23, 2021
Make money, save money 💰
Make money, save money 💰
Make money, save money 💰
Stop making money, spend money
It’s not rocket science. You gotta save
Money can be withheld from your paycheck and deposited directly into the account, so you don’t even have to think about it.
Workplace retirement plans offer a great tax-advantaged way to save and invest money for retirement. They are also highly protected from creditors and litigation.
Some employers have automatic enrollment in their 401k or 403b, meaning you will automatically be enrolled, and a percentage of your paycheck is withheld and deposited into your account. Other employers require you to opt-in.
If you have to opt-in, you can either do this on the retirement plan website for your employer, or by filling out enrollment forms and submitting them to HR. Clarify with your company what needs to be done to sign up.
Either way, make sure you get signed up and start contributing once you are eligible to contribute.
Many companies restrict eligibility to full-time employees (working over 1,000 hours a year) who are over the age of 21.
Depending on the company, if you meet the eligibility requirements, you may be able to participate day one on the job, or you might have to wait a certain amount of time. Some companies have a 90 day wait until you can enroll, some have a 12-month waiting period.
If there is a waiting period before you can participate, clarify if you can participate the day you meet that requirement, or if you have to wait until the next benefits open enrollment window (a certain month of the year when you can enroll in benefits).
Employer Matching Contributions aka Free Money!
One very attractive benefit of workplace retirement plans is that some employers will match your contributions, up to a certain amount.
For example, a company might match your contributions dollar for dollar up to 5% of your salary. If that is the case, make sure you contribute at least 5% of your paycheck into the plan, so you receive all the “free” money from the employer.
You could also look at a dollar-for-dollar match this way: if you contribute a dollar, you receive an instant 100% rate of return on your money. That’s hard to beat with any investment.
Even if it’s a 0.25-to-1 match, you’re still getting $0.25 for every dollar you put in, effectively receiving an instant 25% return on your money, guaranteed!
Whatever the matching formula is, make sure you contribute at least enough of your paycheck in order to receive the maximum matching contribution from the employer.
Some companies don’t have a match, but instead automatically contribute money to your account, regardless of whether you elect to defer a portion of your salary into the plan. This is most common in Safe Harbor 401k plans where the employer does a fixed 3% contribution for all employees.
Company Profit Sharing Contributions
In addition to an automatic match or Safe Harbor contribution from the company, the employer may also elect to contribute discretionary profit-sharing contributions to your account.
In short, at the end of the year, if the company has profits in the bank account, they may elect to share some of those profits with the employees via 401k contributions.
This would be company money, in addition any matching contributions, deposited into your account.
A vesting schedule is a form of golden handcuffs, where the employer entices you to stick with the company for a certain number of years.
For example, the employer may have a six-year vesting schedule on company profit sharing contributions. This means you must stick with the company for six years to receive all of the employer profit sharing contributions in your account. If you leave the company before then, you will forfeit some of the company contributions to your account.
If the company contributions are small, this may not be a big deal. However, at certain companies, highly compensated employees receive very lucrative profit-sharing contributions (upwards of $50,000/year) into their 401k plan. Leaving the company before being fully vested could result forgoing a six-figure sum in your retirement account.
The money you contribute from your paycheck is always 100% vested in qualified retirement plans, so you’ll always keep what you put in if you leave the company before being fully vested.
Pre-tax vs. Roth vs. After-Tax
Once you are enrolled in the retirement plan at work, you will need to elect a contribution amount to be withheld from your paycheck. You can elect this amount to be contributed to your account on either a pre-tax or Roth basis (or both).
There is also a less common third option called after-tax (not to be confused with Roth, despite some companies using after-tax and Roth interchangeably – not nice, whoever you are).
Pre-tax contributions are withheld from your paycheck before taxes are taken out. For easy math, if you earn $100k in a year and contribute $10k to the workplace retirement plan pre-tax, the IRS only taxes you on $90k of income. Pretty cool!
Any growth in the account is tax-deferred, meaning no taxes are owed as long as the money stays within the account. In retirement, qualified withdrawals (over age 59.5 yrs old) from the account are taxed as ordinary income.
You could be completely retired, not working at all, however much you withdraw in a year from your 401k or 403b, the IRS treats that as if you worked and earned it as income, and taxes it accordingly.
Roth contributions work the opposite way as pre-tax. Money goes in after you have already paid income taxes. So, if you earn $100k in a year and contribute $10k to the Roth bucket in the workplace retirement plan, the IRS still taxes you on $100k of income.
Any growth in a Roth 401k or 403b is also tax-deferred and qualified withdrawals (over age 59.5 yrs old) in retirement are completely tax-free!
There are no income limits on making Roth contributions in a workplace retirement plan. People often don’t realize this since there is much publicity about the income limit on Roth IRA eligibility (and the Backdoor Roth IRA workaround).
After-tax contributions are often mixed up with Roth contributions, because both variations result in money going into your account after income taxes have been calculated.
The big difference is, with Roth contributions, qualified withdrawals in retirement are tax-free. With after-tax contributions, you have to pay ordinary income taxes on the investment earnings when you withdraw money in retirement, making after-tax deposits not very attractive.
Why would anyone do after-tax contributions to a 401k or 403b you might ask? Enter the “Mega Backdoor Roth.”
The standard allowable employee salary deferral into a 401k or 403b is limited (currently $19,500/year as of 2021, plus $6,500 if age 50+). Some employers allow you to make after-tax deposits, in addition to the standard employee salary deferral limit. Many of those employers that allow after-tax deposit also allow you to convert the after-tax money into a Roth account (either the Roth bucket within the 401k/403b, or externally into a Roth IRA).
This enables you to get more money into your workplace retirement account than normally allowed and lets you really build up that Roth bucket for more tax-free money in retirement.
In addition to their regular $19,500 contribution, some people will defer an extra $10k, $20k, even $30k/year into their workplace retirement account after-tax and convert it into the Roth bucket. Pretty fantastic!
Companies that allow after-tax contributions and Roth conversions are somewhat few and far between, but we’re starting to see them more and more every year.
What to Invest In
Once you deposit money into your account, the money needs to be invested. I supposed you could leave it in cash, but then it has no opportunity to grow.
What to invest in really depends on your individual circumstances, goals, need for growth, risk tolerance, etc. Work with your financial advisor to come up with a strategy that is appropriate for you.
A general rule of thumb is to be more aggressive the younger you are and more conservative the older you are. The logic here is the more time you have until you need the money, the more risk you can afford to take, because you have time to recover from potential declines in your portfolio value.
Historically, the more risk you take (up to a certain extent), the more growth potential you have. There is also a greater chance of large declines in value.
In workplace retirement plans, you are typically offered a menu of mutual funds to pick from. Some of the mutual funds will invest in stocks. Other mutual funds will invest in bonds. Stocks are deemed to be more aggressive/risky; bonds are deemed to be more conservative.
Within the stock/bond funds, there is also a sliding scale of risk levels. For example, small company stocks are considered more risky than large company stocks, but give you more long-term growth potential, historically speaking. There’s no telling what will happen in the future.
If you’re unsure of what to do, or merely want a hands-off approach, most workplace retirement plans offer age based mutual funds (target date funds) that gradually shift from aggressive to conservative as you get older.
Compounding & Rule of 72
If we go with the assumption that investments grow over long periods time, despite periods of short term declines, what does that long-term growth potentially look like?
An easy to remember law of math is the Rule of 72. This states that if you divide 72 by the growth rate of an investment, you’ll get the number of years it takes to double in value.
For example, if your investment portfolio grows by 10% per year, it will take 7.2 years to double in value. If your portfolio grows by 6% per year, it will take 12 years to double in value.
Hypothetically, if you have $100,000 in your 401k and don’t add any more money, and you average a 7.2% rate of return on your portfolio, after 10 years you will have $200,000. After 20 years you will have $400,000. After 30 years you will have $800,000. Pretty impressive! Sign me up for that!
In reality, money won’t grow in a linear fashion. One year the account will be up 20%. The next year it will be down 13%. Year after that up 15%. Year after that, up 1%. Sure, the average might be in the mid-high single digits, but you weren’t anywhere near the “average” in any given year.
What if you’re continually adding money to your account? How does this work in practice?
Say you start saving for retirement at age 26 and add $10,000/year to your workplace retirement plan. For simplicity, we’ll assume you never increase your contribution rate and you average a 7.2% annual growth rate.
As you can see from the above table, you’ll have over $61k at age 30, almost $275k at age 40, almost $700k at age 50, over $1.5 million at age 60, and about $2.25 million at age 65! It took almost 30 years to get to the first million, but less than 10 years to go from one million to two million!
That’s compounding for you. It takes a while to get the train rolling, but once’s it’s going, the momentum really picks up.
Want your portfolio to be larger? Give it more time. The reason Warren Buffett is so wealthy is that he’s been investing for 80 years! The majority of his wealth has accumulated after his 65th birthday.
What if you don’t start saving at 26. What if you wait until age 33 to start saving for retirement? Using the same numbers ($10k/year invested, 7.2% growth rate), you would only have $1.3 million at age 65. Almost a million dollars less.
In order to get to the same $2.25 million total at age 65 as in the previous example, you would need to save $17,000/year starting at age 33. That’s an extra 70% more per year that you need to save in order to reach the same end amount! It pays to start saving a few years earlier if you can.
One more scenario to look at. If you start at age 26 and max out your account every year and assume the maximum contribution limit increases by 2.5%/year to the nearest $500. We’ll stick with the 7.2% annual growth rate.
As you can see from the table above, the trajectory is similar to the first scenario, but everything is amplified by contributing the maximum allowed at a presumed increasing rate each year. It takes almost 20 years to hit your first million, but from there the balance goes up six-fold over the next 25 years.
Of course, these examples are hypothetical and for illustrative purposes only. The point is to show the power that compounding can have.
When Can I Withdraw Money?
As it currently stands, you are prohibited from withdrawing money from most qualified retirement plans until you are over the age of 59.5 years old. There are a few exceptions, but if you withdraw money before then, you are subject to additional penalty taxes on the money.
Therefore, it’s best to leave your retirement money in a retirement account until you retire or turn age 60, whichever comes later.
What if I Leave My Employer?
When you leave an employer, you typically have several options for what to do with the money.
1. You can leave the money in that retirement plan. Some employers will force you to take it out if the balance is below $5,000.
2. You can roll the vested balance into your new employer’s retirement plan. This is not a taxable event, because you are doing a like-to-like account transfer. This option is attractive for people who want to consolidate accounts and keep the money in a workplace retirement plan.
3. You can roll the money into an IRA or Roth IRA (if you have a Roth balance in your 401k/403b account). This is common for people who are retiring, or who want more control over how their money is invested.
4. You can convert your old pre-tax retirement account into a Roth IRA. Doing so is a taxable event – you have to pay ordinary income taxes on the amount converted (due the following April when taxes are due). This is an attractive option for people who are currently in a lower tax bracket than they expect to be in later in life. Pay a smaller amount of taxes on the money now, avoid taxes on the money coming out in retirement.
5. You could cash out the account and pay the penalty taxes. Not advisable.
Save for retirement! Save early, save often. The more you save, and the sooner you start saving, the more you will have in the future.
Get on the correct side of compound growth. It will take a while to realize it’s benefits, but your future self will thank you if you make saving for retirement a priority now.
There are many nuances and rules within workplace retirement plans. The biggest ones you should familiarize yourself with are the matching contributions, vesting schedule, and whether you make pre-tax or Roth contributions.
At a minimum, contribute enough to get the maximum company match. Learn the vesting schedule within your retirement plan, so if you’re thinking of changing employers, you know how your account balance will be impacted.
Whether you do pre-tax or Roth contributions to the 401k or 403b account is up to you. Generally speaking, if you’re in a high marginal tax bracket, pre-tax contributions are more attractive. If you’re in a lower marginal tax bracket, Roth contributions are attractive, in my opinion.
I’ve already mentioned it, but the most important piece of the equation is how much you save. That’s the biggest thing you can control. The higher your savings rate, the more financial mistakes you can make along the way and still end up well off.
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This should not be construed as individualized investment or tax advice. Investments involve the risk of loss, including total loss of principal. Any examples are hypothetical and for illustrative purposes only. Consult with your tax advisor for tax implications for your specific circumstances. Consult with an asset protection attorney in your state to learn specific ramifications for you.
Roth IRA distributions tax - free if made 5 years after the initial contribution to the plan and you are over 59 1/2.