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How much should you contribute to your 401(k) plan? Are you overwhelmed by the investment selections for your retirement plan? These questions can be crippling. To quote the French philosopher Voltaire, “The perfect is the enemy of the good”. (“Le mieux est l’ennemi du bien”). The sooner you start contributing, the more time your money will have to grow. It is important to just get on with it.
The Decline of Pensions
There was a time when you worked for thirty years for the same company, and then received a pension at retirement with guaranteed income for life. The first private sector (i.e. non-government) pension plan was established in 1875 by American Express Company, which at that time specialized in shipping of goods. These days, only 14% of employees at private sector companies are enrolled in pension plans (also known as defined benefit (DB) plans). The beauty of these plans, from the perspective of the employee, is that there is guaranteed retirement income based on his/her length of employment and salary. The company assumes investment risk. In addition, the pension plan managers work with actuaries to model longevity of employees, so that the company can anticipate total payout per employee and earmark funds for its pension plan. There are a number of reasons that pensions are being phased out in companies, including volatility in the stock market, increasing longevity of employees, and of course, companies’ drive for profitability.
The Rise of 401(k) Plans
In 1978, a law was enacted enabling employees to contribute pre-tax dollars to a 401(k) plan, with the possibility of employer match (known as a defined contribution (DC) plan). What this means is that you are assuming the role previously taken by pension plan managers. You must decide how much to contribute and how to invest those funds (within the selections offered by your company plan).
The Basics of 401(k) Plans
- You may contribute pre-tax dollars to your 401(k) plan, which reduces your taxable income.
- Money, contributed pre-tax, in your 401(k) plan will accrue tax-deferred (the government will get taxes eventually).
- For 2014, you can contribute up to $17,500 to your 401(k) plan.
- For 2014, if you are 50 or over, you can contribute an additional $5500 per year.
- Many companies will match your contribution to a certain level, as part of their benefits package.
- There is a 10% penalty for withdrawing funds before the age of 59 1/2, with some exceptions.
- You must start taking distributions around the age of 70 1/2 and pay income tax on the yearly required minimum distribution (RMD), with some exceptions.
- There is a 50% penalty if you fail to take the annual required minimum distribution.
Disclaimer: As with all things tax-related, please consult with an accountant or financial planner for questions specific to your situation.
The Sooner You Start, The More Money You Will Have
Using an online calculator, let’s compare two employees and what they do with their 401(k) plans. Jane starts a new job at age 30 and is making $100,000 per year (with 3% annual raises). She elects for a 10% contribution, and there is no employer match. If she continues contributing to her retirement plan until age 65, she will have accrued about 2 million dollars (this assumes 7% annual return on investments).
John is working for the same company as Jane, with same salary and annual raises. He doesn’t think about retirement until he turns 45. If he starts deferring 10% of his salary at 45, and continues until age 65, he will have accumulated 1.2 million dollars.
Bottom line: Jane and John will have contributed similar amounts of money to each of their 401(k) plans over the course of their career, but Jane will have almost twice as much saved because she started earlier.
How Should You Invest the Money?
You are constrained by the investment choices of your 401(k) plan. You will want to diversify across asset classes using low-cost funds. The simplest choice for those disinterested in investing are target-date funds (also known as life cycle funds).