One of the biggest advantages of a 401(K) is the high contribution limits set by the IRS. These limits may change annually, so check for new limits each year. Additional limits called ‘catch-up’ limits may apply to those over 50 years of age.
These funds can all be ‘pre-tax’ contributions, meaning you are able to reduce your adjusted gross income, which determines the rate of tax you pay to the Federal Government.
The minimum contribution your employer requires to obtain the full company match should represent the minimum contribution level you save for retirement. Once you have cash set aside for emergencies, consider increasing your 401(K) contributions. If you haven’t looked at it in a while, a good place to start is considering an additional 1% per year in contributions.
The more you are able to save for retirement, the more options you will have when you reach retirement age.
According to a recent Federal Reserve Board Survey, 40% of Americans don’t have $400 set aside for an emergency.
It’s not IF life is going to throw you curveballs, it’s when. Having cash available for emergencies is extremely important. Saving for retirement is only one of the savings buckets you should be contributing to and maintaining.
Other areas to consider include:
In addition to saving for emergencies, you should also set aside cash to achieve other long term financial goals including buying a house, having a baby, or saving for a child’s education. Set financial goals for yourself and commit to saving money often and early.
Saving can seem daunting when you’re just starting out. So be mindful that everyone’s got to start somewhere. Direct deposit is a great tool for meeting savings goals. Consider setting up payroll direct deposits when available or setting up automatic transfers from your checking account. Another consideration is to increase your rate of savings if you earn a raise or bonus.
Once you have met these savings goals, you could consider making contributions to a taxable investment account which has the opportunity to grow.
The purpose of a 401(K) is to save for retirement. Federal guidelines allow withdrawal from a 401(K) for financial hardships which include payment of tuition for post-secondary education and a down payment for the purchase of a principal residence. However, it’s best to save for these expenses separately. The longer your retirement savings are able to be invested and the more money you are able to contribute the better off you are going to be when you reach retirement age.
It is also important to understand the financial consequences of making a withdrawal from your 401(K) before age 59 ½. The IRS may impose a 10% penalty on any funds withdrawn that are considered ‘earned income’. Taking a big lump sum withdrawal could push you into a higher tax bracket, causing a big tax bill at year end. Lastly, when a withdrawal is made for financial hardship, your 401(K) plan may mandate you refrain from making additional contributions for a period of at least 6 months.
The stiff tax penalties, possible halt in contributions, and reduced principal balance which remains invested makes your 401(K) savings an unattractive and expensive source to fund big ticket purchases. It would likely be in your best interests to begin a direct deposit savings program and wait until you have accumulated the funds needed for your purchase.
Participant loans should only be taken under the most extreme circumstances. Generally acceptable reasons to take a participant loan include paying back taxes or other money owed to the IRS and to avoid bankruptcy. If you are unable to avoid bankruptcy, retirement assets are generally protected.
The savings you have been able to accumulate in your 401(K) can seem like an attractive source of financing if you’re in a pinch. But before tapping into those funds, it is important to ensure you are fully informed of the process and consequences – both good and bad of taking a participant loan.
Not all 401(K) plans allow participant loans, so check with your plan administrator about what your plan allows.
| Pros | Cons |
| Borrowing from a 401(K) may represent a better option compared to high interest loans such as payday, title, and credit card loans. | Some plans do not allow contributions while a 401(K) loan is being repaid. |
| The interest rate on a 401(K) loan is interest you pay to yourself instead of a lender. | You may miss out on your employer’s match.
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| 401(K) loans offer a quick solution to getting out of a financial pinch. | The IRS limits loans to the lesser of $50,000 or 50% of your vested balance. Repayments must occur via payroll deduction within 5 years with interest. |
| If you lose your job, the loan must be repaid in full within 60 to 90 days. If you are unable to meet this obligation, the loan will be converted to a distribution, triggering a 10% tax penalty if under the age of 59 ½. | |
| Distributions are treated as earned income, meaning taxes will be due at the time you file your tax return. | |
| Repayment of a participant loan will cause you to reduce your tax efficiency. Loans are repaid with after tax dollars. When funds are withdrawn during retirement, they will be taxed again, resulting in double taxation. | |
| If you are unable to make contributions during the loan repayment term, your Adjusted Gross Income will likely be higher, which could cause a higher effective tax rate. | |
| Unless the loan is repaid quickly, it represents a permanent setback to retirement planning as you miss out on compound growth. |
Paying off debt and paying for emergency expenditures are the primary reasons people take out 401(K) loans. If you are tempted to pull from a 401(K) remind yourself, that those funds have to last you the rest of your life. If the 401(K) remains your best option, ensure that you are borrowing small amounts of money for the shortest duration.
Before taking the participant loan, research other options such as payment plans, a part time job, and better budgeting or lifestyle changes. It’s best to avoid the temptation of borrowing from 401(K) by preventing the need in the first place. Start a savings plan to build up an emergency cash fund to cover unexpected expenses – for ideas on how, reference # 3 in Haven’s ten part series.
If making your investments work harder means holding riskier assets, your plan may backfire – especially if you are approaching retirement. Most investors have “loss aversion” which refers to the tendency to prefer avoiding losses more strongly than acquiring gains. Everyone likes to see their portfolio appreciate in value but no one likes to see it decline. By holding higher concentrations of riskier assets, your upside potential does increase but so does your downside.
When constructing financial plans for clients, we typically assume an investment return between 6% and 8%. Often, this rate of return is able to sustain a comfortable retirement if the client has followed a disciplined savings plan and makes reasonable withdrawals from their retirement savings. Haven’s financial advisors make asset allocation suggestions for existing clients who have outside 401(K)’s.
A 401(K) should be considered a long term passive strategy. This means, you pick an asset allocation for yourself, ex. 60% Stocks 40% Bonds then select Mutual Funds from your investment choices that meet your objective.
It is important to understand that mutual funds must follow an investment mandate despite market conditions. For example, a large cap growth fund will invest in large cap growth companies regardless of the relative performance of this asset class to the general market.
For this reason, it is wise to maintain positions in index funds which provide general market exposure. You can use an actively managed fund to compliment the market return, but you must be willing to accept the increased risk associated with these investments.
You should also consider that it is very difficult to consistently outperform the general market. If you use an actively managed fund, you should review its performance periodically to ensure it is achieving better or consistent returns to its benchmark.
Frequently, investors are motivated to change investments in an effort to chase past outperformance of a particular fund. It’s important to remember that past performance does not imply future results.
Most 401(K) plans charge a fee to reinvest assets, some mutual funds also charge load fees every time you trade in or out of a security. If these fees are high, frequent trading can quickly erode any performance benefit as fees paid offset the return you are able to retain.
You could also be missing out on income from dividends and interest by frequently trading. Over time, income producing securities can contribute a lot to your overall performance.
The advisors at Haven Wealth Group suggest reviewing 401(K) investments every 6 months to ensure the funds are performing well against their benchmarks. Asset allocation changes should always be considered in the context of the current market.
You should continue to make contributions to your 401(K) through all market cycles. If market volatility is a concern, consider a more conservative allocation. Some options to consider may include income focused funds such as Equity Dividend Funds, Fixed Income Funds, or Stable Value Funds depending on the market environment.
If you are overly concerned about new dollars loosing value, one option would be to change your future contribution election to a 100% stable value money market or cash equivalent fund. This change would keep your existing dollars invested, but protect the principal of new dollars contributed.
The risk of using a cash equivalent is missing out on a market rally as cash and its equivalents would not be expected to outperform stocks and bonds over a long period of time. For this reason, it is very important that you set reminders for yourself to ensure your contributions are invested once the market stabilizes. At that time, you should rebalance your entire portfolio as well, to ensure the cash accumulated is invested and has the opportunity to grow. Be mindful that by using a cash allocation you are likely to miss out on upside once the market begins to recover.
An investor should always research what the mutual funds they hold are invested in to consider if it is meeting their investment objectives. It is wise to set an overall asset allocation strategy then select the funds that will meet this objective.
Target date funds follow an asset allocation model which changes automatically as time progresses. Typically these funds become less “aggressive” as they approach the target year by reducing exposure to stocks and increasing exposure to bonds and cash. However, you cannot rely on the assumption that fixed income investments are always safe. In a rising interest rate environment, bond prices fall, increasing the likelihood of loss of value in bond mutual funds.
Target-date funds are often perceived to be safer than other funds, but in reality, they can be more aggressive than expected. This is because the asset allocation strategy of the target fund does not change in response to market conditions. For example, during the financial crisis of 2007-2008, equity and international exposure was maintained despite a severe correction.
Assuming that a target retirement fund can be ‘set and forgotten’ may leave investors disappointed if the fund’s asset allocation is not ideal for current market conditions.
Finally, as with all mutual funds, you should educate yourself about the fees charged by a fund. Target retirement funds have been known to have higher rates of fees than typical index funds. It’s wise to compare the fees charged across all your investment options and take this in consideration before selecting an investment.
Money market funds should be considered a cash equivalent. The benefit of Money Market funds is that generally speaking, they preserve principal and pay a small amount of interest. The flaw of money market funds is that they underperform other asset classes 98% of the time.
One of the benefits of participating in a 401(K) program is that the assets you contribute to the account have the opportunity to grow. If you choose a high allocation to a money market fund, your rate of growth will likely be low and may not keep up with the rate of inflation. This could mean it will be necessary for you to contribute more or work longer to reach your retirement goals.
Use of money market funds for a portion of your 401(K) is a good way to reduce volatility in times of correction. However, you are likely to miss out on upside when the market begins to recover. Timing the market accurately is exceptionally difficult, even for the professionals who watch markets and economic indicators daily.
Rolling over a 401(K) into an IRA is a great idea if you have a plan to manage your investments. As with all important investment decisions, you should educate yourself on the benefits of each investment vehicle.
| IRA | 401(K) |
| May offer lower fees | May assess high administrative fees, or highly feed investment choices |
| More investment choices | Investment choices are out of your control, you must use the mutual funds offered |
| Distributions are easier once you reach retirement | Distributions must follow plan rules, and are often feed. |
| Offer the ability to consolidate 401(K)’s collected from previous employment | Can roll over old 401(K)’s from previous employment into your current 401(K) plan |
| Can be managed personally or by an Investment Manager. | You manage your investments. However, trade restrictions may be in place limiting reallocation. |