Retirement Planning – Traditional 401K Account
Employers nowadays are rarely providing pension plans also known as defined benefit plans which used to be the norm in the past. Fortunately, mid and large companies are now usually offering the so called defined contribution plans which are a little different than a fixed pension. They allow the employee to make payroll contributions to a retirement account. The most popular retirement plan accounts are 401K account and 403b, the latter representing similar arrangement like 401K but eligible for non-profit organizations. There are other retirement plan options like safe harbor 401K, SIMPLE 401K, Roth 401K, however in this particular post we will focus our attention to a traditional 401K and later we will discuss others.
The benefits of a traditional 401K account can be various depending on the employer. The most general advantage that does not depend on the employer is that 401K plan assets can grow tax deferred. This means that all contributions invested in funds may accumulate dividends and capital appreciation that is not going to be taxed right away, given they have positive returns year over year. What is more, all contributions to the 401K account are deducted from your income before calculating taxable wages for the year. Hence, investing in 401K account will decrease your current income tax bill based on all contributions and at the same time regardless of your activity in the account all net gains are not going to be taxable in the current year but deferred to the time of withdrawals.
Some of the general characteristics of traditional 401K plans are that they have contribution limits. You can contribute up to $18,000 per year for 2015-2019 period. If the plan participant is over 50 years of age he/she can contribute $6,000 more for a total of $24,000 per plan participant per year. The additional $6,000 are called catch up contributions and are dependent on the specifics of your plan so be sure to review if they are allowed.
In addition to the employee contributions employers can also contribute to the plan account. Employer contributions may be matching dollar for dollar the employee deferrals or it can have different matching formula. Vesting schedules for the employer contributions are also very common. Taken all contributions together they cannot exceed 100% of the compensation or $54,000 for 2017.
Important characteristic of 401K account is the distribution schedule. By the age of 59 ½ distributions usually are subject to 10% penalty in addition to the income tax that needs to be paid. Exceptions to this rule are situations with financial hardship or medical needs. After 59 ½, if the account owner is retired he can start taking distributions. If the account owner decides to continue working though at age 70 ½ he will be subject to required minimum distributions (RMDs) unless the 401K is sponsored by his current employer. The first RMD should be taken after April 1st following the year when the account owner turns 70 ½. If RMDs are not taken penalties can amount to 50% of the RMD value.
After we looked at savings and spending rules for 401K account it is time to look into the investments in the plan and how to decide which ones are the best for us. Depending on the plan administrator the 401K plan can offer different investment options. Often you will have domestic stock funds, international stock funds, bond funds and target funds. Diversification is always a good practice. Beware however of the risk of naïve diversification (Allocating equal amounts in all funds available or funds that are highly correlated). In order for the diversification to work you need to choose funds that are not correlated. A good example will be investing in bonds and stocks to achieve diversification. Your strategy could be 50% Stock fund and 50% Bond Fund. The so called target funds can do this allocation for you and change the percent weight depending on how close you are getting to retirement. This luxury though comes at a price as target funds are usually more expensive than broad market passive funds. In order to compare fund prices you should look at the prospectuses and see what their net expense ratio is. It can range from as low as 0.02% up to 2-3%. This is important as a quick analysis on the performance of a 401K based on S&P 500 for the last 50 years taken into consideration monthly contributions and an average of 40 consecutive years of work life returns not more than 5-7% annual return. The expense ratio can well eat up half of your returns. Hence, a good strategy will be to choose broad market passive funds with low expense ratio and diversify as much as possible with funds that are not correlated.