Most people think about their company 401k plan as a way to save for their future. This is correct, but it can also be a great tax deduction. Under this current tax environment, it is hard to reduce your tax burden when you work as an employee of a company. However, when you put pre-tax money into a 401k plan, it as if you never earned the money, which in turn lowers your tax bill at your highest tax rate. The US tax rates are progressive, so assuming your highest tax on your income is 34%, you are saving 34 cents to each dollar that you put pre-tax into your 401k plan.
Most 401k plans give you an option to save pre-tax, thus you are not taxed on the money now but will pay taxes at the point of withdrawal later. The idea, though, is that you will be in a lower tax bracket in the future. Another option is contributing to the 401k plan’s Roth. Roth contributions are taxed now but then grow tax free. Typically, if household income is less than 150k and you are under the age of 45, I recommend contributing 100% to the Roth portion, or at least 50/50 to pretax and Roth. Every family is unique, so I recommend consulting with your financial planner first before finalizing these allocations.
Deciding how much you should be saving is the start to every financial plan. A good rule of thumb for young people is to start saving at least 10% of your income in your 20s. If you are starting later, then you will need to be saving at least 15% of your income. The more you save early will allow you to reap the benefits of compounding over a longer time period. If you are a late saver, don’t give up, but you have to put more dollars in since you don’t have the long time period for growth. For 2022, the max contribution to a 401k plan is $20,500 plus an additional $6,000 if you are over the age of 50.
If you have no idea on how to allocate your 401k plan, stick to the target date funds that correspond to your retirement year. These funds will automatically become more conservative as your retirement year approaches. A target date fund is a fund of funds, so you have the diversification that you need and typically the fund fees are low. You either use these funds or you don’t, meaning you don’t need these funds and others. Investing a large balance into a target date fund is ok. It is better than choosing the wrong allocation using the plan’s other options.
The next level of asset allocation is to build your own portfolio. We build these for our clients to make sure that the allocation matches their financial plan. You want to focus on the low-cost index funds within the plan to reduce the risk of poor performing actively managed mutual funds. Low cost, diversification, and a long-term focus is the winning combination in portfolio building.
Your behavior in managing your 401k plan has a lot to do with your success. Studies have shown that the average rate of return for individual investors is 4%, while the market has generated 8%. This gap has been coined the behavior gap due to buying stocks near highs and selling near lows. This greed and fear-induced trading destroys the wealth building process. The most successful investors are building good allocations and continuing to invest a portion of each paycheck while ignoring the markets during scary and volatile times.
Taking time each year to review the cost of your retirement plan, how you have allocated funds and evaluate how much you can contribute will fine tune your nest egg. This will then allow you to successfully look forward to taking care of yourself and your family for 30+ years.