Supercharge Your 401k

How to Leverage Matching Contributions and the Power of Compounding

a tachometer maxed out in the red

My dad didn’t worry too much about retirement. He was a truck driver, and the Teamsters offered a pension plan. He figured that with Social Security in his future, he didn’t need to spend too much time fretting about money for his golden age.

My, how times have changed!

The 1980s were the halcyon days of pensions. Some 38% of workers had a pension back then. They mostly were defined benefit plans in which the company contributed a certain amount of money toward their employees’ retirement. I think I worked for one company that had a pension, but I didn’t stay there long enough to vest.

Today, many government workers can still count on pensions, but only about 18% of us in the private sector have a pension, according to the Bureau of Labor Statistics. Part of that decline is due to employee turnover (you usually have to remain with an employer for at least 3-5 years before you are fully vested in a plan, and today, employee turnover is about 40% annually), but the advent of the 401k plan, to which employees and many employers contribute (under a defined contribution plan)—as well as pension fund mismanagement—actually sounded the death knell on the defined benefit plan.

Even if you are lucky enough to have a pension, you may not be able to count on it being there when you retire. I mentioned mismanagement, and that’s a big issue. According to Mercer’s 2020 Defined Benefit Outlook, only 85% of pension plans have the funds necessary to meet their obligations. Mercer lays the blame on “poor investment decisions and greedy assumptions.” But to be fair, one can also blame historically low interest rates that haven’t returned the gains predicted in the funds.

Mercer also projects that “63% of companies with defined-benefit pensions are considering termination of the plan within half a decade. That would mean the pensions would be closed off to future participants.” Ouch!

For those of us still working—with or without a pension—the reality is that we had better take control of our own retirement. There are lots of vehicles to save for retirement, including IRAs, Roth IRAs, Simplified Employee Pensions (SEPs), Keough’s, and 401ks. Today, I want to focus on 401ks because most of those plans offer you “free” money.

401ks – Don’t Pass up Free Money
I’ll get to the free money in a minute, but first, I want to explain how the 401k came about. The 401k was an incidental creation, spawned when Congress passed the Revenue Act of 1978. That act included a provision that was added to the Internal Revenue Code—Section 401(k)—that allowed employees to avoid being taxed on deferred compensation.

Two years later, a benefits consultant named Ted Benna was trying to design a more tax-friendly retirement program for a client and he referred to this Section 401(k) in his research. From that, he created a plan that allowed employees to save pre-tax money in a retirement plan, and, at the same time, allowed employers to match the funds. His client didn’t want to do it, but his company—the Johnson Companies—liked the idea, and it became the first company to provide a 401k plan to its workers. The 401k was originally designed to be a supplement to pensions, but, today, it has mostly replaced them.

Then, in 1981, the IRS decided that employees could use payroll deductions to fund their 401k, which really boosted the plan’s popularity. And according to the Employee Benefits Research Institute, within the next two years, nearly half of all big companies were offering—or considering—401ks.

How a 401k Works
A 401k is an employer-sponsored savings plan specifically designed for retirement. One of its big benefits is that you don’t pay taxes on the money you’ve saved until you withdraw it (unless you have a Roth 401k; more on that in a minute). And, at that time, most of us will be in a lower tax bracket, so our withdrawals should be taxed at a lower rate than when we contributed to our plans.

Not every employee can join a 401k. You must be eligible. In general, you need to:

  • Be 21 years of age or older
  • Complete 12 months of service
  • Work more than 1,000 hours per year or have worked at least 500 hours in three consecutive years. (This was a change as a result of the Setting Every Community Up for Retirement Enhancement (SECURE) Act, effective in 2020, which broadened eligibility requirements)

Almost every year, the IRS changes the employee contribution limits for 401ks. They did not, however, for 2021, and your individual contribution for this year is capped at $19,500. If you are age 50 or over, you can also contribute a “catch up” amount of $6,500.

In addition to your tax-friendly contributions, the IRS allows businesses to match the employee contributions as long as the total amount funded (by you and your employer) is the lower of $58,000 ($64,500 if you are catching up) in 2021 or 100% of an employee’s compensation (up to a maximum of $290,000 in 2021).

Fidelity reports that on average, employers match about 4.7% of their employees’ contributions. That employer contribution is what I call “free money.” If you don’t already know how much your employer matches, find out immediately! Then all you have to do to receive it is to join your employer’s 401k plan and make contributions to it.

And remember, the higher your contribution, the more your employer contributes (up to the limits), and that match of free money will help you grow your retirement fund at a faster rate. So, if you contribute the maximum $19,500 each year, and your employer matches 100%, you are getting another $19,500 for free! Now, why wouldn’t you want to do that? Believe me, when I worked as an employee and 401ks became available, I didn’t hesitate!

I mentioned Roth 401ks earlier. You should know that not every employer who offers a 401k also offers a Roth 401k. But if they do, you may want to consider this option. With a Roth 401k, your contributions are “after-tax.” The contribution limits and employer limits remain the same. The question you must ask yourself is this—do you expect your income to be higher in retirement than it is now? If the answer is no, contribute to the regular 401k, as you will be taxed at a lower rate than you are subject to now. But, if the answer is yes, you think your income will be higher during your golden years, then contribute to a Roth 401k if your employer makes it available. That way, you are being taxed today on your contributions, and then when you withdraw them, you will pay no income tax.

In 1983, about one-half of large firms offered 401ks to their employees. Today, the U.S. Census Bureau says 59% of employed Americans have access to a 401k, but only 32% of them actually contribute to one.

But, as you can see from the following graph, the assets in the plans are significant and are steadily growing.

401(k) Plan Assets
Billions of dollars, end-of-period, selected periods

401k Plan Assets over years

Source: ici.org

Choosing Your Investments
Now that you know what you need to do to be eligible for a 401k and how much you can contribute, you need to find out which investments your 401k offers.

According to the Investment Company Institute, the average 401k plan offers 13 mutual funds, with more than half of the assets invested in U.S. stock funds and target-date funds. Some 401ks offer ETFs too. I love 401ks, so don’t take this in the wrong light. But in my opinion, there are two issues with 401ks—they don’t offer enough investment choices and employers skimp when it comes to educating employees on those choices and investment strategies in general.

There’s not much you can do about the first issue, other than to make recommendations to your employer to expand your plan. But I was so fed up with the second problem that in the last company in which I was an employee, I developed a short course for the other employees to thoroughly explain our 401k options. You may also want to suggest to your employer that they do something similar.

In the meantime, let me give you some ideas of what your choices and strategies may be. Since I don’t know the details of your plans, I’m just going to give you some general information and some common scenarios.

First of all, you need to understand how much risk you are willing to take with your investments. Most investors will fit into one risk category (although a blended approach can work as well).

Investor Risk Profiles
Conservative: As a conservative investor, you are less willing to accept market swings and significant changes in the value of your portfolio in the short- or long-term. Capital preservation is your primary goal, and you may plan on using the principal from your investments in the near-term, preferably as a steady income stream. The average level of return you expect to see is 5%-10%, annually.

Moderate: As a moderate investor, you seek longer-term investment gains. You are comfortable with some swings in your portfolio’s performance, but generally seek to invest in more conservative stocks that build wealth over a substantial period of time. The average level of return you expect to see is 10%-25% annually.

Aggressive: As an aggressive investor, you primarily seek capital appreciation and are open to more risk. Swings in the market, whether short term or long term, do not impact your investment decisions and you have confidence that volatility is necessary to achieve the high return-on-investment you are looking for. You typically expect a 25%+ return annually, though you do not need your principal investment immediately.

In general, the younger you are, the more aggressive you can afford to be, as you have a long time span before retirement. But that also depends on your personal situation—health, family, salary, etc. A few years ago, I devised a simple survey to help you determine your risk profile. You can find it here.

Your 401k plan will generally offer you a variety of risk scenarios. They may be called conservative, moderate, and aggressive. Or they may be labeled Equities, Income, or Balanced. In that case, Equities would be the most aggressive. But understand that different funds—even if they are mostly comprised of stocks (equities) may have varied risk profiles. For example, a small-cap only equity fund will be much more volatile (riskier) than a large, blue-chip equity fund. An income fund will most likely be made up of dividend-paying companies and/or bond funds. And a balanced fund should have some equities and income investments in it.

As you can see, it would behoove you to know the exact investments that comprise each fund. That way, you can determine the risk level for yourself.

Types of Mutual Funds
Mutual funds offer a number of categories, investing styles and strategies. The most popular are equity funds. They are just what they sound like: Funds that invest in stocks. They are categorized as follows:

  • Large cap (>$10billion)
  • Mid cap ($2 – $10 billion)
  • Small cap (<$2 billion)

Additionally, each of these categories may be further divided into:

Index funds are for investors who want funds that follow the broader markets, have lower operating expenses, and lower turnover. These funds offer portfolios constructed to match or track the components of a market index, such as the Standard & Poor’s 500 Index (S&P 500).

Value funds include equities that are priced low, relative to their earnings potential, their peers, or that meet certain criteria as specified by the fund manager (which could include price-to-earnings requirements, or other fundamental criteria).

Growth funds consist of companies with high growth, but also are more volatile and riskier than value stocks and generally priced at a higher premium.

Blended funds are a combination of both value and growth equities.

Sector funds concentrate on one particular sector of the economy. There are sector funds for just about any industry or subsector of any industry. Oil, energy, financial, pharmaceutical, semiconductors, hardware, software—you name it—there’s probably a sector fund for it. While the concentration in one industry can bring fabulous rewards, it can also cause significant losses, making these funds more appropriate for investors who can handle higher-than-average risk.

Bond funds, which invest in fixed-income securities, are also very popular, especially for investors who are more conservative with their money. These funds are available in short-term (< 5 years), long-term (>10 years) or intermediate-term (5 – 10 years) maturity periods.

Balanced funds may include a combination of equities and fixed income investments, “balancing” out risk, but also reducing returns.

Foreign funds offer investors the opportunity to own stocks and bonds of companies outside the U.S.

Additionally, earlier I mentioned that your 401k may include Target-Date Funds (also called Life-Cycle Funds). A target-date chooses assets based on a formula that assumes you will retire in a certain year and adjusts the asset allocation as you get closer to retirement. The target year is identified in the name of the fund. So, for instance, if you plan to retire in or near 2045, you would pick a fund with 2045 in its name.

Target-Date Funds usually offer you a Conservative, Moderate, or Aggressive portfolio, based on your risk tolerance. As you age, you will probably want to monitor and change your allocation to become more conservative.

Key Factors when Choosing a Mutual Fund
Risk is not the only factor you need to consider. As with any investment, you must examine several critical issues:

Performance: The funds’ actual returns (investment appreciation + dividends) are key comparison measures. In a great market, a large percentage of mutual funds will do well; that’s why it is extremely important to look at a fund’s returns over a multi-year period. I would suggest that you compare returns on a 3-year, 5-year and 10-year basis. And it is best to look at the annual numbers, not the cumulative figures, as they will disguise the true fund returns and won’t tell you a thing about the consistency of the performance. For example, if the fund had one really great year, but nine so-so years, the 10-year return might look pretty good, but that would not give you the accurate story of the fund.

Morningstar.com offers ratings (1 to 5 stars) on mutual funds, based on how well they’ve performed against funds in the same category (after adjusting for risk and accounting for sales charges).

There are many websites that offer these statistics, but Morningstar’s is one of the best.

Importantly, please be aware that—just like any other investment—past performance is not a guarantee of future success.

There are several Costs & Expenses associated with mutual funds:

Loads: Some funds charge front-end loads, ranging from 3.75%-5.75% of the monies you initially invest. Note that funds may also charge a front-end load for reinvesting your dividends back into the fund.

Back-end loads may range from 4-5.75% of the funds you redeem or cash out, in the 1st year of ownership, but then may subsequently decline until they reach zero, in about the 6th year.

Some funds do not have front- or back-end loads and are called No-load funds.

Expense ratios: These expenses are the cost of doing business and include administrative and management fees. They are calculated as a percentage of net assets managed. And while they have been declining (mostly due to the proliferation of less expensive ETFs), the current average for actively managed funds is 0.5%-1.0%, but may go as high as 2.5%.

12b-1 fees: These fees are marketing and distribution expenses. They are included in the fund’s expense ratio, but often separated out as a point of comparison. They are charged in addition to loads, and even no-load funds may have them.

Taxes: When a fund manager sells a stock from the fund at a profit, the gain is taxable (if you hold that fund outside of a tax-advantaged retirement account). Short-term gains (for investments held less than one year) are taxed higher, at your individual income tax rate, while long-term gains (for investments held more than one year) are currently taxed at a 15%-20% rate, depending on your income. Many investors tend to forget about taxes on funds since they aren’t privy to the fund manager’s everyday buying and selling of investments and the losses and gains accrued and are often surprised by the tax bite at the end of the year. Consequently, it would be wise to pay attention to the next important item on our list…

Turnover. This refers to the frequency of trading undertaken by the fund manager. The more buying and selling he or she does, the higher the turnover, and the greater the potential tax bite. This is another area in which index funds are advantageous, as their managers generally trade less than actively managed funds, so they usually accrue lower tax bills.

I mentioned that some 401ks also offer a choice of Exchange-traded funds (ETFs). ETFs and mutual funds are both strategies for pooled investing—where your monies are “pooled” with other investors so that you can invest in a basket of stocks. There are approximately 7,602 ETFs around the globe, according to statista.com. And there are almost 8,000 mutual funds, offering investors many choices. Which begs the question—why do companies only offer a choice of 13 funds???

Additionally, both types of investments can be broken down into smaller categories, such as sectors, investing strategy, market capitalization, and others. But there are differences…

ETF expenses are significantly less than most mutual funds. Trading in ETFs does require a broker and their commission. However, the total expenses (unless you are an active trader—and if that’s the case—you shouldn’t be in ETFs), are, on average, much lower than the expenses of mutual funds investing in similar asset categories. The annual expense ratio for mutual funds is 0.50%-2.0% according to thebalance.com), and for ETFs is 0.05% to about 1.00%.

Liquidity and transparency: ETFs can be traded all day long, instead of just once daily for mutual funds. You buy and sell them just like stocks. And unlike mutual funds, with ETFs, you can use limit orders; you can sell them short; and you can trade options.

Less capital gains distributions: Investment turnover in ETFs is not as frequent as in mutual funds, lending themselves to lower capital gain distributions; hence, a smaller tax bite for most investors.

And there are also some advantages that mutual funds have over ETFs, including:

  • Wider variety.
  • No commission fees, unlike ETFs.
  • Less leverage risk. Mutual funds do not generally carry the leverage of some ETFs, so that might make many of them less risky than their comparable ETFs.

What to Do After You Start Your 401k Plan
Wow! You’ve come this far. You’ve (hopefully) maximized your contribution to get that free money and you’ve chosen your investment allocation. So, do you just sit back and watch it grow?

Absolutely not! Like any investment, you need to monitor it. As we all know, life sometimes throws us a curveball or two, and those challenges may mean that you need to change your retirement strategy.

Here’s what I recommend: at least once a year, go back and review your 401k. And when you get a raise or a bonus, pop at least some of that extra money into your plan.

But every year, ask yourself, is my 401k growing the way I hoped? Do I have too much money allocated to a specific investment or strategy? Do I need to add a little risk to increase my returns?

What if You Change Jobs?
Most of us will change jobs more than 6-7 times in our lifetimes. And what happens to your 401k when you take a different career path? Fortunately, you have a few choices. But #1 is this—DO NOT CASH IT IN! I know it looks tempting, but if you do that, you are going to pay a big penalty—10% of your withdrawal.

And you will be severely hampering your retirement plans. So, instead…

Take it with you—You might be able to roll your current 401k over into your new employer’s 401k. If you do, make sure to make a direct transfer to it, so there are no penalties.

Roll it into an individual IRA—You can set this up with your brokerage firm, but again, make sure to directly transfer your 401k funds into the IRA.

Keep your 401k with your previous employer—This may be possible, but I don’t recommend it. Since you will no longer be at that company, you may not always be informed when the employer makes changes to the plan. Better to have it under your control.

Can I Borrow from My 401k?
In some cases, the answer is yes. Some plans will allow you to borrow up to 50% of your vested account balance, up to $50,000. The loan usually has to be paid back within five years, or you may be penalized. And if you leave the company with an outstanding loan, you may be required to pay it back immediately.

When Do I Get My Money?
In general, you can begin withdrawing money penalty-free at 59 ½.

And Don’t Forget about IRAs
I’ll talk more about individual retirement accounts (IRAs) in a future issue, but I just want to remind you that once you have fully funded your 401k, don’t forget to fund your IRA. IRAs also provide tax advantages.

If you’re company matches your 401k contributions, that account is usually going to grow faster than your self-funded IRA, because of the free money that comes with most 401ks.

Below is an example of a person who contributes $2,000 annually to a retirement fund, over a 10-year period. It shows a $2,000 contribution to his 401k with his company matching dollar for dollar, up to 3% of his $50,000 salary (which equals $1,500), compared to his contributing the $2,000 to an IRA.

You can see that his 401k has grown to more than $45,000, whereas his IRA is around $25,000.

 

IRA vs 401k

Source: Image by Julie Bang © Investopedia 2020

That is significant! But it doesn’t mean you should neglect to fund an IRA. That way, you’ll be maximizing your retirement accounts.

Can a Self-Employed Person Have a 401k?
Fortunately, the answer is Yes!

There are several retirement accounts available to the self-employed. In addition to IRAs, those of us who don’t draw a salary can open a Simplified Employee Pension Plan (SEP), a Keough, and a Solo 401k. I’ll talk more about the first two in a future issue and focus on the Solo 401k plan today.

Solo 401ks are also called individual or self-employed 401k plans. These are generally considered a better option than SEPs for a solo practitioner, due to:

  • Employee deferrals. Solo 401ks allow separate employee contribution as well as a profit-sharing contribution, up to $19,500 into the plan for 2021, even if the business loses money in those years. SEPs do not.
  • Catch-up contributions. A solo 401k allows the same catch-up contributions as a regular 401k, for those aged 50 and older. SEPS do not.
  • Roth contributions. Solo 401(k) plans allow for post-tax Roth contributions, whereas SEPs only allow pretax contributions.
  • Loan provisions. As with regular 401ks, solo 401ks allow loans, also equal to the lesser of 50% of the plan balance or $50,000. Loans are not available with SEP plans.

In a solo 401k plan, you can make both employee and employer contributions—up to $19,500 as an employee (or $26,000 if 50 or older), and 20% of your net self-employment income as an employer, up to a total of $57,000 for both types of contributions in 2020.

As for the investments you choose to place in your solo 401k, you have a wide variety, including real estate, precious metals, private equity, private lending, startups, Bitcoin, and other cryptocurrencies… in addition to stocks, bonds, and ETFs.

However, to start conservatively, I would recommend that you first fund your plan with stocks, bonds, ETFs, and mutual funds. And if you’ll allow me to shamelessly promote my own newsletters, you’ll find a variety of ideas in our monthly Wall Street’s Best Digest, Wall Street’s Best Stocks, and Wall Street’s Best ETFs newsletters. If you want to learn more about each of these publications, just visit Financial Freedom Federation, or drop me a line at nancy@financialfreedomfederation.com. I’ll be happy to help you get started.

I hope these guidelines help you decide to go for it—get your 401k established, contribute the maximum to it, and then change your strategy as needed as your life needs evolve.

As always, these are general guidelines; please consult your financial planner, accountant, or attorney, for any questions or advice about your particular circumstances.

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