| If you retire at age || |
At age my will be worth
- A is a retirement savings account that allows you to defer paying income taxes on contributions until your retirement.
- Funds withdrawn from your plan before age 59 1/2 are taxed as ordinary income and you may have to pay a 10% federal tax penalty for early withdrawal.
- The personal contribution limit for a plan in 2015 is . The catch-up contribution limit for employees over the age of 50 in 2015 is .
- Your employer can contribute up to to your through company matching programs.
- You will only pay taxes on your contributions and earnings when you withdraw money. Your withdrawals are taxed as income (not capital gains) but as most people are in a lower tax bracket in retirement than when in the workforce this creates a significant tax advantage. We estimate your tax rate in retirement will be % vs your current estimated tax rate of %.
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Utilizing a 401(k) is a great way to jump-start your savings. The value of your 401(k) at retirement is a function of how much you contribute, the matching provided by your employer and the appreciation of your 401(k) assets. To calculate your 401(k) at retirement we look at both your existing 401(k) balance and your anticipated future contributions, and then apply a rate of return to estimate how your retirement account will grow over time. Your current and future contributions are a function of how much you are saving and any employer matching available. These contributions are made pre-tax and the investments grow tax-deferred. Our models take into account the maximum allowable contributions. At retirement we calculate the taxes paid on the money you withdraw from your 401(k) and any prepayment penalties that may occur if you decide to retire early.
Eligibility: Your employer needs to offer a 401(k) plan.
Maximum contribution: We use the current maximum contributions ($18,000 in 2015 and $53,000 including company contribution) and assume these numbers will grow with inflation over time.
Catch-up contribution: We account for the fact that those age 50 or over can make catch-up contributions. We use the current total catch-up contribution (not including employer matching) limit of $24,000 and assume it grows with inflation over time.
Special catch-ups: We also take into account the special catch-up options for employees with 403(b) plans who have been with their company for 15 years or more, and the special catch-up options available to those with 457(b) plans in the last three years before retirement.
Early withdrawal penalty: We account for the fact that early withdrawals are subject to a 10% additional tax.
Rollovers: We assume transfers and rollovers to eligible plans or IRAs are permitted.
Tax: Contributions to a 401(k) are made pre-tax, investments grow tax-deferred and income taxes are paid on withdrawal at the tax rate applicable at the time of withdrawal.
If you’ve thought for even a few minutes about saving for retirement, chances are you have some familiarity with the 401(k) savings plan. You probably know, for example, that a 401(k) is a type of “defined contribution plan,” and you are probably aware that it receives special tax treatment from the IRS. You may even remember some of the rules regarding early withdrawals and roll-overs—or maybe not.
For anyone who is building a retirement strategy that prominently features a 401(k), it’s important to have a deeper understanding of the plan, both its advantages and disadvantages. In what cases is it most useful? Are there hidden costs? And, most importantly, how does the dang thing work? Before we try to answer that question, however, let’s make sure we understand the basics.
The basics. What does “defined contribution plan” mean again?
A defined contribution plan is any retirement plan to which an employee or employer regularly contributes some amount. Often, the employee chooses to send a fixed percentage of monthly income to the account, and these contributions are automatically withdrawn, directly from her paycheck—no effort required. The money that doesn't go to the employee's take-home pay gradually accumulates, the balance earns interest from investments, and by the time retirement rolls around, it’s grown into a substantial nest egg for the retiree. That’s the idea.
In a defined contribution plan (unlike in a defined benefit plan), there are no guarantees about the income you’ll receive in retirement. That doesn’t mean such plans can’t be just as effective, however, and employers often sweeten the deal by making contributions of their own, straight into your account.
Free money! But why would any employer do that?
To make sure they have a happy (and skilled) workforce! In 1978, when the law authorizing the creation of the 401(k) was passed, employers commonly attracted and retained talent by offering a secure retirement through a pension (a type of a defined benefit plan). The 401(k) created an entirely new system, with more flexibility for both employer and employee. One of the ways it did so was by giving employers the option to “match” employee contributions.
Matching is a very transparent process: for every dollar you put into your 401(k), your employer also puts in a dollar, up to a certain amount or percentage of your income. There’s no mystery here. If your employer promises to match all 401(k) contributions up to 5% of your income, and you contribute that amount (5% of your income) every month, your employer will match you dollar for dollar, every month. It’s a win-win situation. You are doubling your money, and your employer is building a happy workforce.
A common example of such a matching agreement is for the employer to match 100% of all contributions up to 6% of an employee’s income. If you make $100,000 a year, your employer will match annual contributions up to $6,000. So if over the course of a year you contribute $6,000 to your 401(k), your employer will likewise contribute $6,000, and you get $12,000 total. Note that you can still make contributions above 6%, but your employer won’t match those additional dollars. So, if you contribute $10,000 over the course of the year, your employer will only match the first $6,000. Still—that’s 6,000 extra dollars into your account. Nothing to sneeze at. A 401(k) calculator can help you see how these matching contributions or larger yearly contributions can impact your retirement savings.
That all sounds pretty good
And that’s not the only advantage of a 401(k)! Even for employers who do not offer any matching program, every employer with a 401(k) plan is responsible for administering the plan. That may seem like it’s no big deal, but it actually saves quite a bit of trouble for the employees. As an employee in a 401(k) plan, you don’t have to worry about the complicated rules and regulations that need to be followed, or about making arrangements with the funds in which you invest your money—your employer takes care of all of that for you. That’s quite a bit of saved paperwork.
At the same time, employees who participate in a 401(k) maintain control over their money. While employers provide a list of possible investment choices, most commonly different sorts of mutual funds, employees have quite a bit of freedom to decide their own strategy. Whether you are willing to take on a little more risk with your investments, or if you would rather play it safe, there’s probably an option for you.
You mentioned something about special tax treatment?
Ah yes. Perhaps the greatest advantage of the 401(k) is that contributions to a 401(k) savings account are made pre-tax. When your employer sends out paychecks, the 6% (for example) of your income that you’ve decided to contribute to your 401(k) has already been withdrawn, before your employer has withheld anything for taxes. That leaves 6% less income to be taxed, and a lower overall tax bill.
By comparison, think about what happens when you put money in a bank account: your employee sends you a paycheck, but chops off around 30% of it to give to the IRS for withholding taxes. So for every dollar of pre-tax income, you can only drop 70 cents in your savings account. That’s a big difference!
Of course, keep in mind that income sent to your 401(k) is not tax exempt. Eventually, you will pay income taxes on it, but only when you withdraw it. If you don’t plan on doing so for 10, 20, or 30 years, that extra 30 cents has a long time to earn interest. That adds up.
So let’s use the 401(k) calculator to show you how. For example, let’s say you are 40 years old, and plan on retiring at the age of 67. That leaves 27 years for your current investments to gain value. Using the previous example, in which you make $100,000 per year, and your employer matches up to 6% of your income, you stand to earn over $10,000 more by putting your $6,000 in your 401(k) this year as opposed to a standard savings account—even if you assume both will garner the same 4% return rate.
Of course, a large part of that difference is a result of your employer’s matching funds. That extra $6,000 basically makes the calculation a no-brainer. Even without matching, the 401(k) can still make financial sense because of its tax benefits. Let’s go back to the 401(k) calculator to look at that same example—you make $100,000 and contribute $6,000 annually to your savings—but without any employer matching. Even in this case, you will still save an additional $2,000 just by using a 401(k).
Are there any downsides?
Well—yes. A 401(k) really only makes sense as a retirement savings plan, and not as a general savings account. There’s a 10% penalty for withdrawals before your 60th birthday (well, before you turn 59 ½ but how many people celebrate that milestone), and that’s on top of the regular income taxes you will have to pay. That penalty is enough to negate the other financial benefits of a 401(k), so any money you’d like to have ready access to should be saved somewhere else.
Secondly, investments made through a 401(k) often carry risk. As mentioned above, you will select from an array of investment choices with varying levels of risk, and with many of these, it is possible (albeit unlikely) that you may lose money over time. Keep that in mind when deciding how to allocate your retirement savings. It's important to also steer clear of 401(k) plans that charge high fees if you want to keep more of your money working for you.
In all, however, the 401(k) is a great option for you retirement savings. Given the tax advantages, the ease of use and the possibility of those additional matching funds, if your employer does offer a 401(k), you should definitely consider taking advantage of it. Try putting your specific numbers into a 401(k) calculator to see how it could work for you.
Savings: Are People in Your County Ready for Retirement?
SmartAsset’s interactive retirement savings map highlights the counties across the country in which residents are best prepared to retire on time. Zoom between states and the national map to see how each county ranks.
|Rank||County||Median Household Wealth||Social Security Income||Cost of Living||Income Tax as a % of Gross Income|
Methodology How are people in your community doing with retirement savings?
To answer that question we started by creating a financial profile for every county in the country. We calculated a wealth-to-expenses ratio. This is the sum of median household wealth and average Social Security income divided by the cost of basic expenses. We then indexed the ratio to 100, with a score of 100 representing the highest national wealth-to-expenses ratio. This index reflects how easily county residents are able to accumulate wealth given the cost of living in that area.
We then created a tax index by calculating the relative tax burden for a person with $50,000 to spend each year in retirement. We assumed the money was coming from these sources: $22,000 in retirement income (from a pension or retirement savings account), $19,500 in Social Security benefits and $8,500 in work income. Since federal tax will be constant across all locations, we only looked at state and local income tax, dividing it by the gross income of $50,000. We indexed these values to 100, with a value of 100 reflecting the lowest retirement tax burden of any US county. This helps show where people will have to be more (or less) worried about taxes in retirement.
Finally, we added each location’s wealth-to-expenses and tax indices (with the former getting three times the weighting) to yield a final number. We indexed the final number so higher values reflect counties in which residents are the most ready for retirement.
Sources: ESRI, US Census Bureau 2013 American Community Survey, MIT Living Wage Calculator, Kiplinger, government sources