Deep Dives
401(k) Basics

Retirement. If you’re just starting out, it’s like a whole lifetime away. Literally. So you can put off saving for it, right? But what if I told you a retirement savings habit of $100 a month now could mean tens, even hundreds of thousands of dollars more for retirement?

401(k) Basics
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July 5, 2022

Retirement. If you’re just starting out, it’s like a whole lifetime away. Literally. So you can put off saving for it, right? But what if I told you a retirement savings habit of $100 a month now could mean tens, even hundreds of thousands of dollars more for retirement? Time and compounding are your BFFs right now, so it’s important to start early! 

One retirement savings vehicle you may have heard of is a 401(k). A 401(k) is a great tool to save for retirement in a tax efficient way. Investing in a 401(k) allows you to defer (or postpone) the tax on the interest income and growth until retirement. 

How much should you contribute?

Take a look at your budget. After your monthly expenses, how much are you able to save? A good rule of thumb is to work towards saving 20% of your gross income for retirement. This is roughly the amount of savings you’ll need to retire at a normal retirement age and support yourself at the same standard of living from your 60’s to your 90’s (assumes a 5% return). This may be a goal you work towards over the first 10 years of your career; many of us start at an entry level position and work towards a job where we can afford to save 20% for retirement.

What type of contribution should you make?

The IRS sets the 401(k) contribution limits each year. Most 401(k) plans allow you to contribute to a traditional (pre-tax) 401(k), a Roth 401(k), or both. You can make any combination of contributions to these two types of 401(k) up to the annual limit. 

Traditional 401(k)

If you elect a traditional 401(k) contribution, you are able to deduct the amount contributed to your 401(k) from your taxable income in the year you make the contribution. For example, if you’re in a 22% Federal income tax bracket and contribute $12,000 throughout the year to your traditional 401(k), this is tax savings in the current year of $2,640. You may also have a lower state income tax liability as well. 

Contributions, Withdrawals, and Tax Treatments between Traditional and Roth 401(k)s

Once the funds are in your traditional 401(k), they’ll grow throughout your career and paying taxes on the growth is deferred into retirement. However, when you withdraw from this account in retirement, the distributions are taxed at ordinary income tax rates. If you withdraw from your 401(k) account before age 59 ½, you may have to pay penalties. Accordingly, you should look to maximize your 401(k) contributions to take advantage of the tax-sheltered growth, but you have to balance this with savings for other cash needs pre-retirement like a house down payment or maybe your children’s college education expenses. 

Roth  401(k)

If you elect a Roth 401(k) contribution, you’re giving up the tax deduction in the current year for a future tax benefit. You pay income tax on your contribution in the year you make the contribution. Once the funds are in your Roth 401(k), they’ll grow throughout your career and you’ll be able to defer the tax on the growth just like the Traditional 401(k). However, because you paid taxes on the contribution in the year you contributed it, the original contribution and all the growth can be withdrawn tax free in retirement. Put another way, by electing to pay the tax on the income before making the contribution, the growth in this account is tax free forever

One of the big advantages of a 401(k) is that there are no income limits for making either Traditional or Roth 401(k) contributions. To decide which type of contribution is right for you (or any combination of the Traditional and Roth), consider what your taxable income is now, and what your taxable income might be in the future (both pre-retirement and during retirement). Decide when would the best time be to pay the tax on your retirement savings. If there is a lot of ambiguity around your future taxable income, you could always split your contribution between Traditional and Roth so you get some of the benefit of the tax deduction in the current year, while giving yourself flexibility to choose which type of account to withdraw from in the future. 

How to invest your 401(k)

Once you put money in your 401(k), you’ll need to decide how to invest the funds from a set list of options available in your 401(k) plan. A common mistake people make is chasing returns. If you don’t know where to start, you might be tempted to select the investment options with the best performance historically. However, this does not guarantee the best performance results in the future. 

Target Date Retirement by Investment Mix

Target Date Fund

In order to diversify risk you should allocate your 401(k) investment across US stocks, international stocks and bonds. An easy way to do this is to select a Target Date Retirement Fund. Target Date Funds start with an aggressive allocation (90% stocks and 10% bonds/cash). As you approach the target retirement year, the fund manager will re-allocate your investments to a more conservative allocation (50% stocks and 50% bonds/cash) so when you reach your retirement age you are less likely to experience large swings in your portfolio value.

Custom Diversified Portfolio

If your retirement plan doesn’t offer target date retirement funds, or if they are too expensive, you may want to consider building a diversified portfolio from the investment options you have available to you in the plan. Remember this includes US stocks, international stocks and bonds as mentioned above. If you go this route, check to see if you can select automatic rebalancing in your retirement account to make sure these funds stay invested to your target allocation over time. 

Professional Manager

Finally, some retirement plans allow you to opt into a professionally managed portfolio. If you select this service, a professional manager will actively monitor and invest your account. This is the way to go if you want a hands-off approach. Make sure you know the fees the manager charges and are comfortable with them.

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