One of the easiest ways to get started on your journey to achieving your financial goals is by taking advantage of the opportunities you have through an employer-sponsored retirement plan. Not only do these plans allow you simpler access to investment opportunities, but they also provide higher contribution limits, savings options you may not typically qualify for, and (in most cases) free money through matching or automatic contributions made by your employer.
With all the benefits relating to these kinds of savings vehicles (401(k)s, 403(b)s, etc.), it is important to understand the ins and outs to be sure that you are maximizing the opportunities that you have.
The following are some of the most common areas that employees have questions about.
Pre-Tax vs. Roth (and what is after-tax?)
One of the first decisions you are tasked with when enrolling in a retirement savings plan is what type of savings to use. Essentially, this boils down to when you want to pay the taxes on your contributions. Most plans offer at least pre-tax or Roth options.
Pre-tax savings are about as straightforward as it sounds. The money that comes out of your paycheck and is deposited into your retirement account is not taxed as current income. In turn, this means that money, and any future earnings on it, will be taxed as ordinary income when the money is taken out. This translates into current tax savings and slightly higher current take-home pay.
Roth savings, on the other hand, is the complete opposite. The Roth dollars that come out of your paycheck are taxed with the rest of your paycheck and then the percentage of your pay is contributed to your account. Because of this, those dollars, and any future earnings on it, are tax-free down the road when you take the money out. The focus is on future tax benefits and results in slightly lower take-home pay.
If your plan offers an “after-tax” option, be sure not to confuse it with Roth. It sounds as though it works the same way, but with after-tax savings, the earnings portion will be taxed as ordinary income in the future; not as advantageous as either of the other two options. In reality, this option best fits those who are already contributing the maximum amount to pre-tax or Roth savings within the plan.
The answer to whether you should contribute via pre-tax or Roth depends on your tax situation now compared to what you expect it to be when the money is taken out.
- If you are in your lower earning years, expect your lifestyle to become more expensive down the road, or you expect tax rates in general to rise, then it makes more sense to pay the taxes now; utilizing Roth.
- If you are in your peak earnings years, expect a less expensive lifestyle in retirement, or see tax rates decreasing moving forward, then it makes more sense to defer the taxes until the money is taken out; utilizing pre-tax savings.
- For most people, this means it makes sense to contribute to Roth early on in their career, until reaching the point when it makes sense to switch to pre-tax contributions.
Always remember that hindsight is 20/20 and that you will never completely know if taxes are lower now or in the future, until you get there. Because of this, it may make sense to diversify your savings between the two to hedge your bets. [Also, note that any contributions made by your employer (i.e. match) are considered pre-tax and taxes are paid by the employee when the money is taken out.]
How much to contribute?
Once you have decided what type of contributions you are going to make, the next big question is how much you should contribute. Contributing at least enough to capture your full company match is a great place to start. Ensuring you do not leave any free money on the table can go a long way when it comes to achieving your long-term goals.
Keep in mind that 401(k)s/403(b)s allow you to contribute much higher amounts through these tax-advantaged savings options. For 2020, you can contribute up to $19,500 between pre-tax and Roth (an additional $6,500 can be contributed if you are over age 50, for a total of $26,000), leaving you with plenty of wiggle room above what is typically needed to capture your company match.
Due to the tax advantages, and the fact that I’ve never met anyone who wishes they saved less for retirement, I always encourage making the most of the situation and contributing as much as you can, especially if this is the only account where you are saving for retirement.
So, how should the funds in your account be invested? The most important place to begin is breaking down the choices that you have.
Begin with separating “allocation funds” and what I’ll refer to as “do-it-yourself funds”. Allocation funds (i.e. target date funds) are a pre-made mix of stocks, bonds, and other asset classes that make it as simple as choosing your age, when you may want to retire, or your basic risk level. “Do-it-yourself” refers to researching the specific domestic and international, large and small, stock and bond options and piecing the puzzle together into the appropriate investment mix.
There is not one right or wrong way to go about it, but I will say allocation funds are great for those with limited investment experience and who do not have the professional resources to aid in choosing the funds to invest in.
Statistically speaking, about 90% of an investor’s performance is attributed to the mix of asset classes within his or her portfolio, not the specific funds. Because of this, I suggest taking the time to consider your experience and these basics before making a quick decision and second-guessing yourself.
Throughout the years, I have seen consistent issues with rebalancing investments. If you decide to use an allocation fund, then this should not be an issue. However, if you are deciding to change up your game plan or are at a point where you need to rebalance back to your target mix between the funds you chose, remember that there are two steps: rebalancing your current funds in your account AND updating the allocation of funds where your future contributions will go.
The most common mistake I see is that people correctly rebalance the current dollars but forget to update where future contributions are directed. If continued contributions are allocated to an incorrect mix, you are almost back where you started. This usually results in you logging into your account and seeing 20+ investments in your account without being able to remember when or why you chose them.
The financial landscape can be complex and overwhelming. The trick is to take advantage of the opportunities you have and to try and avoid making costly mistakes. Hopefully these few tips and bits of information will get you headed in the right direction early on in your career, when time is a major ally to your success.
As we embark on this clarifying journey together, I encourage you to submit any ideas, topics, or questions to email@example.com. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for any individual.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for any individual. This information is not intended to be a substitute for individualized legal advice. Please consult your legal advisor regarding your specific situation. Clarify Wealth Management and LPL Financial do not provide legal advice or services. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.