If you work for a company, chances are your employer offers a retirement plan in the form of a 401(k). Actually, a 401(k) is just a tax code. This code was created by the federal government to encourage people to save money for their own retirement.
The incentive for saving through a 401(k) is that the money you contribute into your 401(k) is pre-tax. This means you don’t pay income taxes on that money. Let’s say that your income puts you in the 25% tax bracket. When you contribute $8,000 into your 401(k) you’ll save 25% of $8,000, or $2,000 in income taxes!
Additionally, as your contributions grow, the taxes on that growth are deferred until you withdraw the money (after age 59½). At that time, you’ll pay normal income taxes on the money you withdraw. On the surface, this doesn’t sound like a big deal, but it is as we’ll discuss in a future post!
Most people who are somewhat conscientious about saving for retirement (or as I like to say, Financial Independence) automatically sign up for their 401(k) at work even though there may be a better course of action. (Full disclosure: I was one of those people! Since then I’ve figured there are smarter way to do things.)
The Alternative to Your 401(k)
So, if not the 401(k), then what? When saving for Financial Independence your best investment vehicle is the Individual Retirement Account (IRA). The traditional IRA and the Roth IRA feature completely different tax advantages. But, both offer advantages over your 401(k). The tax benefits of an IRA are very much like the 401(k) in that with a traditional IRA you’ll contribute pre-tax dollars and your money will grow tax-deferred.
When you contribute into an IRA you have total control over the investments you can make. Typically, the 401(k) only offers a few investment options. Because of this, you may not be able to select the ideal investment for your strategy. You may have to settle for something “close” to what you want.
For example, you may not be able to invest in an S&P 500 index fund. You may have to settle for a large-cap (big companies) equity fund, or just a generic equity fund.
Additionally, 401(k) investments are usually through a mutual fund. These funds usually have much higher fees and expenses. The average fee for a mutual fund is 1-2% per year instead of .04% for a Vanguard Exchange Traded Fund (ETF), for example. But that’s not all. With mutual funds there are other “operational” costs that also reduce your money’s ability to grow. The problem with these costs is that they’re hidden from the investor. You’ll never see a statement showing all the fees and costs, but they’re there–usually hidden in the prices that you buy and sell the shares for.
The Only 3 Reasons You Should Invest in Your 401(k)
So, I’ve lambasted 401(k)’s pretty well. Why would you ever want to invest in them? The following are 3 very good reasons to invest in your 401(k)–even with their shortcomings.
- You need the structure of automatic payroll deductions and investing.
- You’ve already contributed the maximum amount to your IRA and you have more to contribute.
- Your employer offers matching funds to your contributions.
Structure of Automatic Payroll Deductions
The least important reason is that you don’t have the confidence, technical savvy, or financial discipline to manage the investing through an IRA yourself. Hopefully, as you keep up with this blog you’ll gain all those attributes. After all, that’s the core purpose of this blog! If, for whatever reason, you feel you can’t or wouldn’t make your normal contributions into your savings on your own, the 401(k) is a good way to overcome these fears.
Simply sign up for the 401(k) with your employer. Your contributions will be taken out of your paycheck before you even get paid and they’ll be contributed directly into your 401(k). The company that’s managing the 401(k) (usually a mutual fund company) will automatically invest that money into the investments you’ve chosen. Nothing can be simpler.
You’ve “Maxed Out” Your IRA
The second reason why you should invest your money into your 401(k) is that you’ve “maxed out” your contributions into your Individual Retirement Account (IRA).
If you’re under the age of 50 there’s a limit of $5,500 a year that you may contribute into an IRA. If you’re 50 or older, you may contribute an additional $1,000 as a “catch-up” for a total of $6,500 per year. Once you hit the limits of how much you can contribute into your IRA, if you still have money you want to contribute into your savings, the 401(k) is perfect for your remaining contributions.
While offering you a significantly reduced number of investments, and usually at higher expenses, the ability to contribute more pre-tax dollars and have them grow tax-deferred are benefits that overcome those shortfalls.
Employer Matching of You Contributions
By far the most important reason for you to invest through your 401(k) is when your employer elects to “match” money that you’ve contributed into your 401(k). This reason is so powerful that it trumps any reason you may have for starting with an IRA. Companies get to set their own rules concerning how much (or even if) they add matching money to your 401(k) contributions. But, even if they only add a small amount, you must take advantage of this great benefit.
If your company only offers a 50% match on a limited amount of your contributions, you get instant growth on the money you save. Sometimes it may take several years for your contributions to grow 50%. If you can have it given to you right up front, take it!
The company’s matching to your contribution is part of your compensation. If you don’t take full advantage of this you’re leaving money that you’ve earned on the table. Make every effort to contribute enough into your 401(k) to collect ALL of the matching funds your employer is willing to pay. If any of these 3 reasons apply to you, you should be using your 401(k) to save for Financial Independence. Otherwise, you should start with an IRA where you can control expenses and select investments that are ideal for your strategy.
Why is This Important to You?
The difference in being able to choose lower cost investments (Vanguard ETFs) over higher cost ones (mutual funds) can result in over $500,000 more in your savings after 40 years. That extra half million dollars can make a big difference in how and when you declare Financial Independence.