In the early 1970s, Kodak approached Congress about creating a program where their employees could invest a portion of their salary in the stock market. They also suggested that this investment be tax-exempt, hence the birth of the 401(k). It was a great idea in theory, but it may not be as good as you think. Your 401(k) sucks but it might be the only investment vehicle you have.
Even though it may not be the best retirement savings vehicle, it might still boost your retirement savings. So, here are few reasons I have a love/hate relationship with the 401(k) and how you can take advantage of its benefits:
One of the greatest benefits to a 401(k) is the employer match. A match is when your employer will contribute an additional percentage to your 401(k) based on the amount you contribute. For an example, you contribute 6% of your income and your employer will contribute up to 4%. If you make $60,000 you would be contributing $3,600 and your employer would be matching $2,400. Taking that a step further, if you don’t get a raise continue to contribute the same amount for 20 years, your investment will be $1,449,616.34 (assuming 7% interest).
If you decide not to contribute, you could be missing out on free money. Even if your employer plan isn’t the best, any help with your savings is a win. So, if you are going to participate in your company’s 401(k) program, make sure to get the full match.
Limited investment options and advice
Unless you have a background in finance and investing, it may be challenging for you to select the correct investment portfolio for your 401(k). On top of that, you may have limited investment options. All investment options are selected by the plan administrator and depending on your plan administrator, they may not select a large variety of options that are suitable for every employee.
In addition, there is limited guidance when it comes to selecting the best investment mix for your financial goals. If you don’t know what a mutual fund is, how are you going to select an appropriate portfolio to match your risk tolerance? And for people approaching retirement 401(k)s typically not offer much in the way to hedge risk.
Fees can be steep and hard to find
I’m sure the first question you asked your employer wasn’t: “what is the fee structure in our 401(k) plan?” If you did, you are probably one in a million (this stat was made up for the record). Inquiring about your company’s 401(k) fee structure is not common. The fees are generally hidden and almost impossible to find on your own.
If you are unsure of the fee structure you can ask your Human Resources department to help you locate them. Some of your mutual funds may also have internal fees that you are unaware of. Do your research and make sure you understand what you are paying for.
You will need to pay taxes
If you decide to invest in your traditional 401(k) you will need to pay taxes on your distributions. Once you reach age 59 1/2 you may be eligible to take distributions from your 401(k) plan. There are rules and regulations that apply depending on your situation. This means that if you have let’s say, $100,000 in your 401(k) account, in retirement you actually have $78,000 assuming a 22% tax bracket.
Like they say, nothing is certain like death and taxes.
So, what can you do?
Diversify your investment strategy and hire a tax professional and financial planner to navigate you through the murky waters of retirement planning. Your 401(k) plan can be a part of your overall financial plan, but you will need to open different types of accounts to lessen the tax burden and help you build a secure financial future.
For example, you may want to open a Roth IRA. Unlike a traditional IRA or 401(k) you contribute to the account with after-tax dollars (keep in mind there are contributions and income limits). This means that when you go to take out distributions after 59 ½ you will not owe taxes. So, if your Roth account was $100,000, you get to keep $100,000. Opening a Roth account can also help pay for some of your taxes in retirement.
Your financial advisor can help you create a plan that will best fit your retirement goals and objectives. Even if your 401(k) plan sucks, your advisor can help you invest in other investment vehicles that may be a better fit in order to achieve your goals. When it comes to 401(k) plans, make sure you aren’t missing out on the contribution match, educate yourself, and hire an advisor that can help you with your financial journey