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What's So Fun About a 401(k)?

Spoiler Alert: there is not much that can be said about a 401(k) being fun. But understanding '401(k) Retirement Planning' is crucial for financial security. Many employees in their 30’s and 40’s know the value of an employer-sponsored retirement plan. A recent survey by Betterment found that overall 74% of employees would leave their current job for one with better financial benefits. Included in that, 79% of Millennials (ages 26 to 41) and 84% of Gen Z (25 and under) would leave. The benefit they are seeking the most is a high-quality 401(k) or other retirement.

When it comes to contributing, the numbers go down a lot. A Bank of America study found that only about 55% of Gen Z and Millennial employees contribute. We know or have heard that it is important, but it's simply no fun. Why is it important to start as soon as you can and what flexibility do you have if you do. A key aspect of 401(k) Retirement Planning is beginning your contributions early.

The Importance of Starting Young

The value of saving early isn’t just that you have a longer time to accumulate savings for retirement. You are also amassing savings that you can borrow from. While contributing to a retirement plan means reducing your available income, it may also reduce the amount you pay in taxes. But when you’re at the start of your career, the tax benefit may not seem like it outweighs the loss of funds every month.

Early career may also means high expenses, a high debt load, and lower total income to meet those expenses. It can be very tempting to kick the retirement can down the road and let 40-year-old you, with your student loans paid off and a bigger salary, handle the retirement savings load.

However, expenses tend to expand to the level of your income, so saving never really gets easier. But more importantly, saving even small amounts and investing over a longer period harnesses the power of compounding.

Let’s assume you start at age 42 and save $500 per month. Assuming an 8% annual return, by age 65, you’ll have accumulated $395,866, not accounting for taxes or inflation.

If you start at age 22 and save only $100 per month, under the same assumptions, you’ll have $451,169 at age 65.

The value of saving early isn’t just that you have a longer time to accumulate savings for retirement. You are also amassing savings that you can borrow from.

Borrowing From Your 401(k)

Your plan sponsor determines the rules for 401(k) loans, but you may be able to take out as much as 50% of the total value of the account. Loan amounts are not taxable, and you won’t incur a penalty on the funds. However, the loans are not open-ended; you generally have to pay them back, with interest, within 5 years of taking out the loan. If you default, you’ll have to pay taxes and penalties – but the default won’t impact your credit score.

The good news is that the interest you pay goes back into your account, along with the principal. So while you are removing money from the investments you’ve decided on in your plan, and you will forgo any growth on the funds, you will get some benefit.

The not so good news is that you’ll miss out on any potential investment earnings. While you are borrowing the funds, they will not be invested in the market. Another consideration is that while your original contributions may have been with pre-tax dollars, you will have to use after-tax dollars to pay the loan.

Retiring at 55 and Rule of 55 for 401(k)

Since you’ve started amassing retirement savings early, you may have the option to retire early and not wait until you’re in your 60s. However, 401(k) withdrawals before age 59 ½ usually incur a 10% penalty.

Per the IRS, the Rule of 55 enables workers who leave their job for any reason to start taking penalty-free distributions from their current employer’s retirement plan once they have reached age 55. The plan works well for workers who want to retire early and those who require cash and thus tap distributions from their retirement plans sooner than is typically permitted. However, not all plan sponsors offer this option.

Normally, distributions from tax-qualified retirement plans, including 401(k) plans, before age 59 are subject to a 10% early withdrawal tax penalty. However, the Rule of 55 may enable an employee to obtain a distribution at age 55 and not be subject to the penalty for early withdrawals. A distribution would still be subject to an income tax withholding rate of 20%. However, if you owe less than you earmarked for the annual 1040 form, you will receive a refund after filing annual returns.

Another important consideration, the employee’s funds must be kept in the employer’s plan before withdrawing them, and the employee can only withdraw from the current employer’s plan. If the employee rolls over the funds to an IRA, the Rule of 55 tax protection is lost.

While retiring early, at age 55 or sooner, is an option, we typically encourage individuals considering this to plan accordingly. Let’s say, for example, you plan to retire at 55 (compared to 60) and live until 85. When you retire at age 55, not only are you reducing the number of years of your contributions (5 fewer years of contributions and growth), but you are also extending the duration of your retirement by 5 years. You are essentially asking less money to last for a longer period of time.

What is a Roth 401(k)

A Roth 401(k) is a employer-sponsored retirement savings account that is funded using after-tax dollars. A Roth 401(k) is similar to a traditional 401(k), but one of the main differences is that for a traditional 401(k), your money is not taxed until you withdraw it. But for a Roth 401(k), you pay the taxes now therefore when you withdraw it, it’s tax free.

There are many advantages and a few disadvantages of a Roth 401(k). We usually encourage contributing to a Roth 401(k) when you can because not only can you contribute after-tax dollars, but there are no income limits and they have higher contribution limits compared to Roth IRAs.

The Bottom Line: 401(k) Retirement Planning is Key

Saving early and often in a 401(k) may not seem like fun now, but it can help to ensure a good retirement later. You are also creating a source of funds you can borrow from and giving future you the option to retire much earlier. Most importantly, you are building your savings “muscle”, which is a very important part of a successful financial plan.


About The Author

Alchemist Wealth is led by the expertise of Andrew J. Tudor, CFP®, RICP®, CAP® and Fred Tudor III, AFC®, MBA. Alchemist Wealth serves clients as a fiduciary specializing in providing fee-only financial planning, investment management, and retirement planning services. With over 2 decades of combined experience in financial services, Fred and Andrew bring a wealth of knowledge and personalized solutions to meet your financial goals.

The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.

This content not reviewed by FINRA


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