Today marks the 40th birthday of the Revenue Act of 1978, and thus the 401(k).
The act was signed into law on November 6, 1978 and established the foundation for the 401(k) retirement savings plan. With the days of corporate pensions firmly in the rear-view mirror, the 401(k) now leads the pack as the retirement savings plan of choice for private companies.
To celebrate, here are five reasons you need to be contributing to a 401(k). But before we dive into the list, what is a 401(k)?
A 401(k) is a tax-deferred employer-sponsored retirement savings plan. Said more simply, the 401(k) is a way for you to save for retirement via direct payroll contributions. With annual limits currently at $18,500 and increasing to $19,000 in 2019, it’s an effective way to begin to save for retirement.
Here are 5 reasons why you need to contribute to a 401(k) retirement savings plan:
1. Save Money on Taxes
Contributions to a 401(k) plan are tax-deferred. In practice this means that your taxable income in your working years will be lower, saving you money on taxes in, presumably, the years you’ll be in the highest tax brackets.
You should note that once you start to withdraw the money, it will be taxed as regular income, but you’ll hopefully be in a lower tax bracket during your retirement years.
2. You Will Save More for Retirement
One of the largest perks of an employer-sponsored retirement plan like a 401(k) or 403(b) is the ability to get matching contributions from your employer. Whether your employer matches part or all of your contribution, it’s a surefire way to accelerate your savings. Unfortunately, not all employers elect to make matching contributions.
If your employer does match your contributions, you’re essentially earning a guaranteed investment return on your hard-earned money. Guaranteed risk-free returns are an investor’s dream.
3. Automation Makes All the Difference
Research by behavioral economists shows that automating savings results in individuals saving more of their money for the future. This makes sense for a lot of reasons.
Consider this: If you hand someone a marshmallow in the morning and ask them not to eat it until 6pm, there’s a chance they’ll eat it during the day. However, by not giving them the marshmallow until 6pm (unless they ask for it), you greatly increase the likelihood that they’ll wait to eat it. The same applies to retirement savings.
By taking the money directly from your paycheck and investing it, you’re greatly reducing the likelihood that you’ll spend the money, since you won’t see it in your paycheck. Even the best-intentioned individuals who skip the 401(k) with a plan to invest the money on their own, will eventually learn the hard way, that they would’ve likely saved more by relying on automatic payroll deductions.
4. Choosing Your Investments is Simple
With the advent of target date funds and low-cost index funds, choosing how to invest your 401(k) is a lot more simple than you think. You’ll want to focus on diversified, low-cost investments.
When it comes to target date funds, you’ll want to find investments with an expense ratio of 0.5% or lower. Target date funds are simply investment funds that automatically adjust your portfolio to lower it’s risk as you age. They’re perfect for individuals that want to choose their investments once and then forget about them. Some 401(k) administrators don’t offer the lowest cost investment options, so you’ll want to do the best you can with what they offer.
You’ll want to use the same criteria when it comes to choosing the best index funds. Fidelity recently launched a no-fee total market index fund (FZROX), so the bar for expense ratios on the index fund side is even lower. Try to select index funds with an expense ratio of 0.3% or lower, if possible. Lower fees means that you’ll keep more of your money.
5. Higher Contribution Limits Than IRAs
Finally, with annual contribution limits of $18,500, a 401(k) will allow you to save more for retirement than an IRA, which has contribution limits of $5,500. In an ideal world, you’ll want to utilize and max out both investment vehicles to supercharge your retirement savings.
Whether you plan to utilize your 401(k) for the tax benefits, the employer match, or another reason, these plans offer multiple benefits. You just have to make sure to take advantage of them.
I am often asked whether you should refinance your student loans in order to save money or invest in cryptocurrency. The kicker, is that I then find that the individual isn’t taking advantage of their 401(k) employer match.
So today, I can think of no better way to celebrate the 40th birthday of the 401(k) retirement savings plan, than to ask you to take advantage of it.
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