Dr. Penny Pincher founded the popular personal finance blog Penny Pincher Journal in 2013 and has published two books about saving money.
How Does 401k Work?
Last week, I had an opportunity to attend a 401k workshop from Fidelity to learn more about 401k investing and how to use a 401k plan for retirement. Even though the information was presented by Fidelity, it applies to 401k plans from other investment companies as well. I learned some new things that will help my grow money for retirement and possibly even retire early.
401k is a way to invest money for retirement that has significant tax advantages. You can contribute income to a 401k fund on a pre-tax basis. This is a huge advantage- an automatic 30% or so advantage right off the bat compared with using after-tax income for investments. Another tax advantage of 401k investing is that your investments grow on a tax-deferred basis. This means that you do not have to pay taxes on your investments as they grow in value- another huge advantage.
In addition to tax advantages, you might be able to get free money if you invest in a 401k plan. Some employers provide matching funds up to a certain percentage of your income. For example, your employer may match your contribution at a 50% rate up to a limit. Let's say your company matches at 50% up to 3% of your income. This means you could contribute 6% of your income (pre-tax) to the 401k plan and your company would contribute 3%. Company matching funds is free money- you should certainly take advantage of this if your employer offers this benefit.
401k Retirement Plan
When you invest funds in a 401k retirement plan, the funds can be invested in stocks or bonds. Most programs allow you a range of investment options for your funds. If you are a long way from your retirement date, you might choose a more aggressive investment portfolio that includes more growth stocks. These investment choices may be riskier, but provide more potential for growth. As your retirement date approaches, you may want to move funds into less risky stocks and even bonds and cash accounts. As you get closer to retirement, there is less time for your investments to bounce back if they take losses in value.
Some 401k programs offer investment choices that automatically adjust the portfolio of investments based on your planned retirement date. For example, the investment fund may have a date in the name- for example "Freedom2035". This fund would be managed to change from more aggressive investment strategies to more conservative investment holdings as the year 2035 approaches. This type of fund is a good option if you are a "hands-off" investor and do not want to worry about moving funds around yourself. Fidelity offers "SSgA" funds for hands-off investors, and other investment companies also offer funds that automatically adjust their investment portfolio based on your retirement date.
Fidelity 401k Investment Strategy (Also Works for Other Funds)
The primary options you can use to manage your 401k investment strategy are setting your contribution amount, and selecting the investment funds where your funds are held. As I discussed, you can choose different investment accounts for your funds based on your growth objectives and level of risk tolerance.
Your contribution amount is a big factor in determining how much money you will have in your 401k account at retirement. Many 401k programs allow you to change your contribution at any time. Of course, you should contribute as much as possible to maximize your retirement fund, but how much should you invest?
The main factors to consider are the pre-tax contribution limit and your company match limit. Let's start with the company match limit- this should be the minimum % of your income that you contribute. Going back to our example, if your company matches at 50% up to 6% of your income, then you should contribute at least 6% of your income so you can get the full company match. Otherwise you are leaving free money on the table!
The next limit to consider is the pre-tax contribution limit, currently $18,000 per year for most income levels. If you take $18,000 and divide it by your pre-tax income, this will give you the maximum you can contribute to your 401k plan on a pre-tax basis. The pre-tax contribution limit can change every year, so check your investment company's website to get the latest limit. If you have enough discretionary income to invest up to the pre-tax limit, this is a good move. You save on taxes and have an investment that grows without taxes.
You can also contribute to a 401k plan on an after-tax basis. Above the pre-tax contribution limit, you will be contributing funds without the benefit of deferred taxation.
Reaching Retirement with 401k
A 401k investment is a great way to grow investments for retirement savings. You can contribute to a 401k on a pre-tax basis, your money grows without tax, and your employer may contribute free money to your account. This is a great benefit and can greatly increase your ability to save for retirement.
Your main decisions for 401k investing are how much to contribute and which investment funds t select. I would recommend investing at least the company matching limit to get all of the free money you can. If your cash flow allows, invest up to the pre-tax limit currently $18,000.
At the Fidelity 401k investment workshop I attended, the consultant spend some time talking about reducing credit card debt so you have more money available to invest in 401k funds. He said the average American is paying 14.9% interest on credit card balances. Some people don't contribute to a 401k plan at all, or contribute less than the level to reach the full company match because they do not have enough cash left after they pay bills.
It is worth some effort to find ways to reduce your spending so you will have more available to invest in your 401k plan.
401k Advice for Everyone
No matter how much or how little money you have available to invest, it is a good move for you to contact your employer's benefits office to find out if they offer a 401k plan. If so, make sure you invest as much as you can to get all of the tax benefits and free money that is available to help you build funds for retirement.
If your workplace does offer a 401k plan, almost all of the investment companies offer free consulting. You can talk with an investment adviser to make sure you are getting the most benefit you can from participating on your 401k program.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2015 Dr Penny Pincher