It’s not uncommon for folks with 401(k)s to feel a bit confused by some aspect of them, or even overwhelmed. You may need help choosing among the investment options your company offers (most provide choices between bond and stock funds). In fact, it could be helpful just to have a debriefing on what 401(k)s are, how they can power your retirement, and how much to contribute.
An independent financial advisor can help with all these aspects of 401(k)s! Your company may provide some information on its 401(k) offerings, but what they provide may not necessarily be clear to you, and you may have questions or concerns about your own individual situation.
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Here’s a brief rundown of 401(k) best practices and how they can help your financial life, and how to work with a financial advisor to optimize them.
401(k)s: A Great Tool for Retirement
401(k)s are retirement savings plans. They are part of a category known as defined contribution (DC) plans, meaning that employees contribute to their retirement (unlike pensions, which employers alone contribute to).
Employees need to choose a percentage of their salary as their annual contribution. So the first choice you need to make it how much of your salary to contribute.
The answer depends on several factors. It can help to work with a financial advisor on 401(k)s because the choice can be complex. First, of course, you want to work with a plan toward your retirement savings, knowing how much you need to contribute for a comfortable retirement while maintaining enough for your budget. A financial advisor can help you with both.
401(k)s can be great savings vehicles just because you can save a lot with them. The 2021 maximum contribution is $19,500 annually, and that will rise to $20,500 next year. That’s far more than the maximum contribution with other retirement plans, such as Individual Retirement Accounts (IRAs), where the maximum contribution is $7,000 annually.
Not only that, but people aged 50 and over are allowed to save an additional $6,500 per year in 401(k)s, for both 2020 and 2021. If you are older and need to catch up on your retirement savings, 401(k)s can help.
Second, many employers offer a match on employee contributions to 401(k)s. In other words, if you are saving 3 percent of your salary, and your employer offers a 100 percent match, they will also contribute 3 percent, making your total savings in a 401(k) plan per year 6 percent.
If your employer offers any kind of a match, you are passing up free money if you don’t contribute. Many employers will match up to a certain percentage of your salary, so you need to know what it is. If your employer will match up to 6 percent of your salary, it’s prudent to aim for the 6 percent contribution, so you get a total of 12 percent of your salary put toward retirement.
401(k)s: A Great Tool for Tax Planning
401(k)s can also provide a considerable break on your taxes, in several ways.
First, the contributions are taken out of your paycheck pretax if you participate in a traditional 401(k). That means you are not taxed on the money you save for retirement at all, which lowers your taxes.
It also can lower your tax bracket, because it lowers the overall taxable income you report to the IRS for the year.
Both your and any employer contributions grow tax-free until you withdraw them at retirement. This is an enormous benefit because it allows maximum appreciation with no tax bite until retirement.
Some employers offer a Roth 401(k), which has a slightly different tax benefit. Roth contributions, unlike those in traditional accounts, are made with after-tax money, so do not have an initial tax advantage. The money grows tax-free until you retire, just like that in a traditional 401(k). The tax savings in Roth 401(k)s come at retirement. Unlike withdrawals from traditional 401(k) accounts, Roth withdrawals are not taxed (because you have already paid tax on them when contributing).
What difference does that make? Well, it can make a profound difference when you’re retired! If you save in a 401(k) when you’re young, your retirement income may be higher than it is when you contribute. That means your tax bracket in retirement may be higher currently is. You may save money on taxes in retirement by investing in a Roth, where $3,000 withdrawn is $3,000 to you.
But if your current taxation is likely higher than it will be at retirement, the benefit comes from contributing to a traditional 401(k). You receive tax advantages now and are taxed at a lower rate on your retirement withdrawals.
It can be prudent to have a mix of traditional and Roth 401(k) contributions. It’s wise to discuss the choice with a Bay Area financial advisor because they can project your taxes in multiple scenarios so you can make an optimal choice.
Choices, Choices, Choices
It may also be prudent to discuss your investment choices with a financial advisor. Again, most companies offer an array of asset choices, usually stock and bond funds. Some may offer a choice between U.S. and international stocks or bonds as well.
Asset allocation is very important in retirement investing. Briefly, stocks generally have the highest return on money invested. But stocks are also risky because their value can fall as well as increase. In some years, stocks are in a bear market (a loss of 20 percent or more). You have to evaluate your risk tolerance.
However, it’s not prudent to avoid stocks completely. Why? Because inflation generally runs at 2 percent each year. Inflation diminishes your purchasing power. Stocks are currently the only investment whose appreciation may keep your investment funds ahead of inflation.
Both bond funds and savings accounts provide stability. While bond prices can fluctuate, the changes are minor compared to stocks. Savings accounts do not fluctuate at all. However, interest rates on bonds and savings accounts are currently low, around 1 to 2 percent, much less than the annual average return of stocks.
As a result, most retirement portfolios combine stocks (for maximum appreciation) with bonds or cash (for protection against risk and some appreciation).
Discuss your choices and asset allocations with a financial advisor to ensure that your money is invested for maximum benefit to you.
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