For most people retirement planning is synonymous with investing in 401(K) or 403(B) plans as employer-provided tax advantage retirement vehicles are the most used retirement planning tools. Quite frankly, they are some of the best vehicles out there for the average employee. They provide great ways to defer money from your payroll on a pre-tax, or post-tax, basis for retirement. Here are some tips for optimizing your retirement savings through your employer provided 401(K) or 403(B).
The old Chinese proverb by Lao Tzu goes “A journey of a thousand miles starts with the first step.” Interpreting it in terms of building your retirement nest egg, if you aren’t contributing to your 401(k) / 403(B), do it now! The sooner you get started the closer you will be to building a nest egg that can help you retire with peace of mind.
Now even if you are facing challenges in your life, you should still contribute in your 401(k) / 403(B) account to at least the minimum your company will match. For instance, if your company matches on the first 6% you defer, then put minimum 6% away. If you are not doing the minimum contribution, you are leaving literally free money on the table. Beyond the minimum contribution whatever extra you can contribute will be a huge plus but doing the minimum contribution should be a first and foremost priority.
The general rule of thumb is to elect a minimum of 10%-15% of your salary from day one to defer into your 401(k) / 403(B) account. This will typically have you in a pretty good position when it comes time to retire. Don’t think about doing all the savings in later part of the year. Nobody can predict future; you might encounter some emergency due to which you might not be able to maximize the contribution in later half of the year. Also, last few months of the year also are filled with holidays. What if did some impulse shopping and are unable to maximize your contribution. So, it makes sense to start contributing into your retirement account from the beginning of the year.
If the minimum target to save is the company match, and the minimum target for a good retirement savings rate is 10%-15%, then what is the maximum we can contribute? Well, in 2022 if you are under 50 years old you can contribute $20,500 with a $6,500 catch-up amount for those 50 or older. Everyone’s goal should be to max out as soon as they can. However, highly paid employees may be restricted in their ability to make 401(k) contributions. A 401(k) plan can elect to stop salary deferrals once a participant’s compensation reaches $305,000 in 2022 and can only use up to this amount when providing a 401(k) match. For the 2022 plan year, an employee who earns more than $130,000 in 2021 is a Highly Compensated Employee. Also, keep a lookout year-to-year on the maximum as the government tends to increase these limits frequently.
A cool feature that will help big time is the auto increase feature. This is one feature that everyone should check/enable when they sign up It will increase your 401(k) contribution 1% a year until you hit the IRS maximum. Most people don’t even notice the marginal change as it is usually offset with the yearly pay increase and it goes a long way in getting your retirement savings on the right track.
Many companies these days offer both a pre-tax option and a Roth 401(k) option. Whatever you choose or even a mixed combo is still subject to the IRS limits in aggregate. Thus, not allowing you to contribute $20,500 to both accounts. That said, which account should you invest in? This is a personal decision and one that you should discuss with your financial planner. As such a good rule of thumb is the higher your income bracket is, the bigger the benefit of pre-tax contributions are as you’ll likely be in a lower tax bracket at retirement. Of course, the opposite is true for Roth 401(k) contributions. If you are in a modest tax bracket it may be better for you to contribute to the Roth and take the tax hit now in hopes of never paying taxes on those dollars ever again. Keep in mind, whatever type of account you choose the company match always goes into a pre-tax account.
This is a great question and the best way to answer this is to consult with your financial planner. A good financial planner can see how much you are earning and based on your unique needs how much you will need in retirement. Having said that, for a quick reference guide go by these guidelines suggested by Fidelity based upon a study it has done of retirement portfolios it holds. At age 30 you should aim to have one times your yearly salary saved in your 401(k), thus if you earn $75,000 your 401(k) balance should be $75,000. By age 40 aim to have three times your yearly salary saved. Age 50 the goal is six times of your yearly salary saved, while at age 60 the minimum target is eight times your yearly salary. This is a good basic guideline to reference while saving for retirement. That said, you can never have too much stashed away in your savings.
401(k) plans can be a little confining if you have investing experience. Because a 401(k)can only be offered by an employer, you’re stuck investing money into a plan with relatively few investing options compared to the almost limitless options of an IRA or traditional brokerage account. As more people become sensitive to investing fees, employers have started offering 401(k) accounts with a brokerage window. A brokerage window allows you to take advantage of the many other investment options outside of a normal 401(k) and yes, it includes stocks, ETFs, bonds, and even some lower risk trading. If your employer provides this option, and you have solid investment experience or guidance, you should definitely look into it. Essentially, the Provider allows you to pay a nominal fee to elect to open a brokerage window within your 401(k) account. You can then move your balance within the plan to this brokerage window. Once it is done, you’ll have many more investment options, rather than the normal dozen or so your provider offers. However, this can be overwhelming and risky if investing isn’t your strong suit. Good news is that you can easily get someone to help you with investments, and investing in stocks and bonds does not carry any investing fees.
Once you start making deductions, the next big hurdle is, how to allocate your 401(k). Conventional wisdom is the younger you are the more “aggressive” or equity-based your allocation should be. However, it is a personal decision based on your goals and risk tolerance. You should look at what are the investment options offered by your 401(K) service provider in your plan, and research a little on historical performance and trends of investment options. Choose investment offerings based on this research and your investment goals.
Most 401(k) plans these days offer ‘No Brainer’ target date funds. These are funds where you choose a retirement date and basically let it ride. The funds will shift through the years to a more and more conservative allocation or more bond-focused as it starts getting close to your target retirement date. For some, these are simple and get the job done. However, if you have experience with investing, you don’t have to put your funds in the Target Date Funds. Keep in mind, that most of these Target Date Funds have additional costs associated with them. Also, the fact of the matter is the investing, and investment allocation is a very personal decision so generalizing it with a Target Date Fund should be your last choice. The investment choices should be based on goals and needs, rather than arbitrary age allocation. If you are uncomfortable making investment choices by yourself, reach out to your 401(K) service provider to get help.
Often missed or misunderstood by many is the option of rebalancing your retirement portfolio. By selecting this option (semiannually if not quarterly) your 401(k) portfolio will be rebalanced at your chosen interval back to your preselected allocation. You may ask why is it important. Because funds performance is not guaranteed so with the passage of time you may find your 60/40 Stocks / Bonds allocation has drifted into a 90/10 Stocks / Bonds allocation which may leave you exposed and out of your comfort zone.
Another question that comes up time and again is whether to go with actively managed funds or passively managed (index) funds while selecting funds in your retirement portfolio. Frankly speaking, there are benefits to both. During certain time periods, and for certain sectors that will benefit from both active and passive management. It is advisable to get exposure to both in hopes of smoothing out the ride.
It is a good idea to hold different funds in different sectors within your retirement portfolio. This will help you in smoothing out the ride a bit and you won’t end up putting all your eggs in one basket. It also can go a long way in protecting the downside from one sector decimating your retirement savings.
Don’t forget to take care of your old 401(K) with your ex-employers. Roll them into an IRA or Roth IRA depending on how you contributed in the first place. This way you will have endless investment options vs. the handful that your ex-employer is offering. If you consolidate them into a single IRA it will become more manageable and you won’t have to spend endless hours taking care of multiple IRAs with multiple providers. Rollover of an old 401(k) into an IRA is tax-free to do and relatively easy. In the long term, you will see enormous benefits from this move.
Once a year you should audit your retirement accounts. A retirement account is not like your checking account that you need to keep a close eye on. However annually or semiannually do an audit of the account and check for the following:
Last but not least, see if you can do a Mega Back-Door Roth. A Mega Back-Door Roth is a special type of 401(k) rollover strategy used by high earners to deposit funds in a Roth IRA account. This strategy only works under certain circumstances for people with extra money they would like to stash in a Roth IRA. In short, if your employer allows after-tax (different than Roth 401(K)) contributions, you can contribute above and beyond the $20,500 limit (up to $61,000 including all sources if under 50 or $67,500 if you are 50 or over) to an after-tax bucket. Then typically once a year you can convert just the after-tax dollars to a Roth IRA of your own effectively making a substantial Roth IRA contribution each year from already after-tax dollars. If this sounds complicated it probably is so it would be probably better to get help from an investment professional.
If you keep on following these tips year after year, you will have a stellar nest egg built by the time you are ready to retire.
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