“It all seems so complicated”
Dear Dan,
I’ll be graduating in December and starting my first “real job” in January. They offer a 401(k) so I’ve been reading about them. There are a lot of articles talking about changes coming to 401(k)s and various aspects such as traditional 401(k) versus a Roth 401(k) and how vesting works. It all seems complicated. Is it even worth it for me to enroll when I start?
—New Hire
Dear New Hire,
It is probably a great idea to enroll and start using a plan as soon as you are eligible. If you take a step back and look at the big picture for your life, you will likely want to retire someday and live off more than just whatever Social Security may pay.
To do that you need to save some of your earnings. The earlier you start, the more you can accumulate. 401(k)s and similar plans provide some features that can help you accumulate more than saving outside of a retirement plan.
An underappreciated feature of 401(k) plans is that saving is done automatically for you through payroll. Your contributions are taken out of your pay, so you never have to take the added step of making a deposit.
Most plans offer a range of investment options that allow you to structure your choices to suit you. This flexibility becomes more important as your balance grows. Plans also offer legal protection from creditors and your vested balance is portable, meaning you do not have to leave it there should you change jobs.
Those features are nice, but the biggest wealth-building features are the tax incentives and employer contributions.
The first tax benefit applies to contributions. Most contributions are made on a pretax basis. When this is done, you pay no income tax on the amount contributed. If you are in the 22% tax bracket, every $1,000 saved pretax lowers your tax bill by $220. So, $1,000 goes into your account but your take-home pay is reduced by $780.
The second tax benefit is deferred taxation on earnings. If that $1,000 makes 5% interest, the $50 is not taxed when earned as it would be in a nonretirement account. If that $1,050 also made 5%, that adds an additional $52.50 bringing the total to $1,102.50. That may not seem like a big deal but if your investments compound at 5% per year for 30 years, you will more than quadruple your money. After 40 years your $1,000 at 5% will be worth more than $7,000.
When an employer makes contributions on your behalf, the earnings on those funds are deferred as well. If your $1,000 is matched and also earns 5%, your balance would be $2,100. So, for every $1,000 that gets matched, you reduce your take-home pay now by $780 but in 40 years at 5%, you’d have over $14,000. Save more than $1,000, and save every year, and it can add up to a significant sum.
Now, there are limitations to these plans. Chief among them is the 10% penalty for taking distributions before age 59 ½. New laws allow for greater access to plan balances than in prior years, but ideally, those should not matter much because the compounding and accumulation effects work best if the funds are left alone until retirement so you should save into the plan funds you have no intention of needing until your career is over.
I’ll get into traditional versus Roth investments and other considerations in a follow-up piece but for now, focus on the basics. As an employed adult, you are probably going to want to buy things, do things, and go places you couldn’t afford as a student. That’s great. Have fun. But do yourself a huge favor and at the minimum, plan on saving into your 401(k) enough to fully take advantage of whatever matching your employer offers. If you can save more, do it. You won’t regret it.
If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line.
Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo serving clients nationwide from offices in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some reader questions are edited to aid the presentation of the subject matter.
Originally published on MarketWatch. Read the original article here.