How to Automatically Get a Return on Your Investment.
Some of the most common questions that come up in conversations with my clients are about their 401k accounts. Their questions mainly have to do with how much they should contribute, what they should invest in, and how the accounts work in general. Just today I received an email from a client wondering if he should change his 401k allocation. While there are many good things to know about your 401k, arguably the most important thing to know is this: does it includes employer matching?
If you are trying to get from point A to point B, most people would want to know the fastest route. When we’re talking about retirement, having employer matching contributions translates to having a shortcut to your destination. Essentially, this is your employer giving you free money, separate from your salary, in the form of a matching deposit to your retirement. The key word there is “matching”, meaning that you have to make a contribution of your own in order for them to match it. If saving for retirement is like building a fire, then 401k matching is like pumping it full of high-octane gasoline.
Sound dramatic? That’s because when you take into account the benefits of tax deferment and compound interest, the effect truly is dramatic. For example, if you are 25 years old and make 5% contributions to your 401k based on a $40,000 salary, by the time you are 65 you would have $473,203 using a 7% average rate return and an annual income growth rate of 2%. However, if your employer matches that 5%, your savings double in the same time frame to $946,406!
In addition to knowing if your employer matches your contributions, there are other factors to understand and take into account depending on your specific situation. Here are some questions to keep in mind and discuss with the financial professional in your life:
How much do you have to contribute to get the full match?
During an initial meeting, one of my clients was seeking out help with his 401k. He claimed that he contributed 4% and the company matched 4%. After a closer look it was evident that only half of his 4% contribution was being matched. This was because his company actually matched 50 cents on the dollar up to 4% of the employee’s salary.
Every company has their own method for how they match, so be sure to know the workings of yours.
Is there a vesting period?
This is especially important if you don’t plan on staying very long with your employer. Vesting periods determine how long you have to be with the company before the funds they are matching in your 401k actually belong to you.
For example, at my second job out of college, the investment company I worked for had a 5-year vesting period with 20% vesting each year. I was there for two years so I only got to keep 40% of the money they had contributed to my 401k.
How is the match treated for tax purposes?
This last nugget of information is one that I consistently find that people are in the dark about. It can get into a pretty in-depth conversation, but for purposes of this post, I’ll just describe how it works.
Nowadays, 401ks give most people the ability to contribute funds on either a pre-tax or an after-tax basis.
Regardless of how you make your employee contribution, your employer’s contributions will always go in on a pre-tax basis. That’s because it helps your employer lower their own tax expense. The main thing to know here is that when you use this money in retirement, you will have to pay taxes on it. This is unfortunate, but hey, it’s still money that you got for free.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.