Retirement is one of the most common financial goals – after all, most people don’t want to work their entire life. That said, retirement statistics reveal that three-quarters of Americans agree that the country is facing a retirement crisis. In this episode of The Agent of Wealth Podcast, host Marc Bautis dives into the first episode of a three-part series on 401ks. Since its inception in 1978, the 401k plan has grown to become the most popular type of employer-sponsored retirement plan in the U.S. Millions of workers depend on the money they invest in these plans to provide for them in their retirement years. Tune in to uncover the mistakes you should avoid.
In this episode, you will learn:
- The advantages of investing in a 401k account.
- How to calculate how much money you need to retire.
- Tax considerations for 401ks.
- Common mistakes relating to 401k contribution plans.
- And more!
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Welcome back to The Agent of Wealth Podcast, this is your host Marc Bautis. On today’s episode we are going to talk about the biggest mistakes I see people make in regard to their 401ks.
Gone are the days when companies provided a pension to retirees. Now, individuals are responsible for saving for their own retirement. Most people use a 401k to do just that. To give you some perspective on how big these plans have become, estimates from last year reveal there was $4.8 trillion dollars held in 401ks across the country.
The intention, when created, was to supplement employee pensions. But over time, they’ve basically replaced pensions. If you want to stop working some day, you’ll need to have assets saved. And the government promotes saving in a 401k by providing some tax benefits for these plans.
I’m going to cover 401k mistakes for the next three episodes of The Agent of Wealth Podcast. Today’s episode will cover mistakes when making contributions to your 401k. In the next episode we’ll talk about mistakes around investing within your 401k. And finally we’ll talk about mistakes made when withdrawing money from your 401k.
Mistake #1: Not Contributing to a 401k At All
Retirement is sometimes referred to as a three-legged stool. How early do you start saving? How much do you save per year? What return are you getting on those savings? All three questions are critical for retirement preparedness, but the two that we’ll talk about in this episode is when to start saving and how much to save.
It’s critical to start saving as early as possible. A commonly used calculation to determine the amount of money you’ll need to save for retirement is 10% of your income from when you start working. So, if you graduated college and got a job, saving 10% every year into a vehicle like a 401k, you’re probably going to be fine by the time you’re in your 60s – meaning you’ll be able to replace your income.
But most people don’t save 10% toward retirement from the day they start working. So they end up playing a game of catch-up. The longer you wait to save for retirement, the more you’ll have to save percentage-wise. 10% can go as high as 20%, 30%, and so on.
I’ve met with people in their 50s, close to retirement age, whose retirement goals are unsustainable or impossible to meet because they waited too long to start saving. Making routine contributions early is critical.
Nowadays, a lot of companies have gone the route of automatic contributions. How this works is as soon as an employee is eligible for a 401k, a percentage – sometimes 3%, sometimes as high as 5% – is taken out of their paycheck to go toward their 401k plan. Of course they have the ability to opt out, but I don’t recommend doing that.
Sometimes these automatic contributions have auto-escalations. For example, in the first year of working for the company, they contribute 3% to their 401k. Then year after year, it increases by 1% until it hits 10%, and that’s where it stops.
When determining how much of your compensation you’ll contribute to your 401k, I recommend calculating how old you are, what you have saved, and how much you need to save to be comfortable in retirement before coming to a conclusion. Many people just go with the minimum contribution, not taking the other variables into account.
Mistake #2: Not Taking Advantage of An Employer Match
Now, on to the second mistake, which is not taking advantage of an employer match. This mistake also seems obvious, but there’s so many people out there that just don’t do it. An employer match is basically free money – take it.
So, let’s say you can’t save the full 10% toward retirement out of your paycheck per year. You should at least target saving enough to get the full employer match. Now, employer matches are all different. The most common one that you’ll see is matching 50% of what you put in, up to 6% of your salary. Using that as an example, to get to a match of 3%, you have to put in 6%, but some are even higher where you can get a match of 4% or 5%.
The employer’s not limited in what they can match. If the plan wants to fall under certain characteristics, one of them is called safe harbor, they have to provide a minimum match. So, the matches come in all different flavors. It’s important to figure out what your plan’s match is, and then make sure you’re at least putting that much in, at a minimum.
Mistake #3: Not Underestimating How Much Money to Save
The next mistake is underestimating how much money to save. The most common question I receive from people is, “Have I saved enough for retirement?” The answer to that question always depends on how much money they’ll spend in retirement, or what their yearly projected spend is. I’ve met with people who saved a million or two million for retirement and think it’s enough, but they forget about taxes and inflation.
Inflation is very high now, but let’s say inflation increases at an average of 3% per year. If that happens, the prices of everything will double every 20 years. But if inflation increases at an average of 5% per year, the prices will double every 14 years.
Another thing that people forget is that for every dollar that you take out of your 401k, a portion of it goes to the IRS. Remember, every year that you’ve made a contribution to your 401k, you get a tax benefit in the form of a deduction. You don’t get a 1099 each year that outlines how much money your 401k earned, and that’s because you get to defer paying tax on any of the income and gains.
But when you take distributions in retirement, you pay tax on every dollar that comes out of your 401k.
So, let’s talk about whether it makes sense to go with pre-tax or the Roth component of it. This determination is going to come down to two things:
- What tax bracket you’re in now, and
- What tax bracket you expect to be in, in the future.
But the benefit to deferring taxes is definitely quantifiable. Let’s look at an example.
Let’s say you have $100,000 in your 401k and you’re going to contribute $10,000 to it per year over the course of the next 20 years. If we use an assumption that you’re in a 24% tax bracket, and that the investments in your 401k are going to get an 8% average return, you’ll have about $925,000 in your 401k after 20 years. After paying tax on the distributions, the 401k has a value of about $775,000.
If we did that same scenario, but saving the $10,000 per year in a taxable investment account, you’d have $696,000 after 20 years. And that’s after paying taxes, so it’s a true $696,000. You’re looking at a difference of $75,000 over 20 years, so there’s definitely a benefit to deferring taxes and investing in the 401k.
Mistake #4: Pausing Your 401k Contributions
Another mistake is pausing – or stopping – 401k contributions. I see this happen a lot when a person starts a family or buys a house, but there’s all kinds of unexpected expenses that can come up. The problem is that it’s really hard to resume contributions once you stop them, because you learn to utilize that extra money that was previously going to your 401k.
My recommendation is to set your 401k contribution at a high percentage – start at 10% – and just forget about it. Hold that contribution sacred and try not to stop it for any reason.
Mistake #5: Waiting Until the End of the Year to Make 401k Contributions
The next mistake is waiting until the end of the year to contribute to your 401k. You’re able to make contributions up to your 401k up until December 31st of each year, and you can do it any way you want to – if you choose, you can pause contributions for the entire year, leaving it to your last paycheck in December. I don’t recommend this. It’s better to automate it and make contributions monthly.
One, you can kind of forget about it. Two, you learn to live without that money. Plus, I’m a proponent of automating anything you can when it comes to your finances. It’s been proven that people have more success with automation versus having to manually take action.
Mistake #6: Overlooking a Roth Option for 401ks
The last mistake I’ll talk about today is forgetting that there is a Roth option for 401ks. Most 401k plans offer two options: pre-tax contributions and Roth contributions. For pre-tax contributions, you get the tax deduction. If you earn $100,000 a year and you make a $10,000 contribution, when it comes time to pay tax, you’ll pay tax on $90,000. But then you pay tax on the distribution. With a Roth account, you don’t get the deduction – instead, you pay tax on money that you earn, and it’s after-tax money that goes into the Roth. But the benefit of a Roth is you never have to pay tax on that money again.
So a Roth takes future tax brackets out of the equation. Now, no one knows what future tax brackets will be. Sure, there’s a good chance they’ll go up. There’s also a good chance that your income is going to increase, moving you into a higher tax bracket by the time you hit retirement age.
When deciding if a Roth is for you, you have to consider what tax bracket you’re in now and what tax bracket you see yourself in in the future.
For example, someone just starting out in their career may choose to invest in a Roth account, because they’re in a low tax bracket. However, in the future, their income may increase, putting them in a higher tax bracket, at which point that pre-tax contribution makes sense.
Something else to think about is the market. We’re midway through 2022 and the stock market has dropped in the first half of this year. So, if you’re putting money into a Roth account now, the idea is you’ll get that growth back, or that growth is under this tax-free umbrella versus the tax deferred umbrella.
So, you really have to look at it from your specific situation. I see people put 50% of their contributions into a Roth and 50% of their contributions into a pre-tax.
Alright, so that wraps up today’s episode. While some of these mistakes are well-known, we’ll talk about mistakes relating to investing in your 401k and withdrawing from your 401k in the next two episodes of this series.
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