Approximately 71% of private industry and state and local government employees had access to a retirement plan at work in 2020. For those employees able to save for retirement in an account that grows tax-deferred until retirement, it could be one of the most valuable employee benefits available.
Here are seven essential best practices to make sure you get the most out of participation in a retirement plan at work.
Save as Much as Possible Today
It is often wise to go beyond the default savings rates many plans automatically use to enroll new hires.
Most financial planners agree that you need to save 10-20% of your total earned income each year throughout the course of your working career to maintain the same lifestyle during retirement.
This approach increases the likelihood you will accumulate enough savings to replace income goals during retirement.
Max the Match
If your employer matches your contributions, be sure to take full advantage of this free money that provides a nice boost for your retirement savings.
Think About Your Current Tax Rate and Future Taxes
Pre-tax contributions to 401(k) plans provide an immediate tax benefit. The size and significance of this tax break depends on your marginal tax bracket. You can estimate the amount of tax savings you will see as a result of pre-tax contributions using tools like this pre-tax savings calculator.
Some retirement plans offer a Roth option, giving you the ability to invest on a tax-free basis. A Roth 401(k) is usually a smart choice if you do not need the current tax benefits of pre-tax contributions, or you anticipate being in the same or higher tax bracket when you begin taking distributions.
Make Future Increases to Your Savings Automatic
It is easy to put our retirement contributions on cruise control and forget to make important changes as time passes by. The downside of this “set it and forget it” mindset is that our financial situations are constantly changing.
Unfortunately, good intentions to save more later on in life aren’t always followed through consistently. That is why behavioral finance experts suggest that you can save more tomorrow through gradual retirement plan increases over time.
Many retirement plans automatically enroll new participants in a contribution rate escalation program. Others allow employees to sign up for this valuable feature at no additional cost. What makes automatic 401(k) savings features even more appealing is the ability to change your mind or make updates to the contribution amount at any time.
Here is an example of how contribution rate escalation works. Michelle is 30 years old and is contributing 5% of her $60,000 salary to her 401(k) plan, with a 1% annual rate increase and a 15% cap.
After 30 years and a 6% average annual increase, the 401(k) balance would be approximately $577,000 compared to $244,500 without the automatic increases.
Don’t have that much time on your side? After 10 years, the difference is still almost $34,000 using the previous example.
Choose the Right Investment Mix for Your Situation
For many retirement investors, portfolio selection can be a challenge. Finding an appropriate asset allocation model requires matching your comfort level with risk as an investor with your investing time horizon.
Many retirement plans now offer static asset allocation funds or target date funds to help plan participants diversify their investments across multiple asset classes (i.e., stocks, bonds/fixed income, real estate, alternative investments).
Avoid Early Withdrawals
It may be tempting to take an early withdrawal, but the long-term consequences are often not worth it. 401(k) withdrawal rules can be complicated, though there are certain situations where penalties can be avoided.
However, if you leave an employer or encounter financial hardships, it is often recommended to avoid early withdrawals from a 401(k) plan.
Only Use 401(k) Loans as a Last Resort
Some positive 401(k) loan features include no credit checks and competitive interest rates. They can be a potential source of funds, but it is often wise to avoid borrowing against your 401(k). There is an opportunity cost—you may miss out on market gains while you are paying interest to yourself.
But the biggest risk is that you could end up owing taxes and penalties if you leave your job and cannot repay the outstanding loan balance. To avoid paying the taxes and penalties associated with early distribution, you would need to rollover the outstanding loan balance to an IRA or other eligible retirement plan by the due date (including any extensions) for filing your Federal income tax return.
Next Steps: Create an Action Plan for Retirement
In order to get the most out of your 401(k) plan, it is important to have a clear vision of why you are saving for retirement in the first place. We all have our own unique definition of what the word “retirement” actually means.
If you want to make sure you are making the smartest choices with your 401(k), take some time to assess your goals and review how many of the seven steps mentioned above you have already taken.
This assessment can help give you an idea of where you stand.