Everyone has probably worried at some point about the future and being able to retire. Do I make enough? Am I saving enough? Where do I invest? How do I invest? All valuable questions, so let’s start in one place – the 401(k). Understanding how a 401(k) works could lead you to make changes to your current contribution level, investments or other options related to your account. This podcast will help break down some of the more complicated ins and outs of the 401(k), and will help you plan for a more secure retirement, whenever that times comes.
Liz: Ah, the American Dream. To not have to worry about money, to be able to maybe retire early and travel, really when it comes down to it you want to be a millionaire! Who doesn’t? What if I told you right now that you have the tools to become a millionaire by the time you retire? You’d be foolish not to listen, right? It’s so simple; it comes down to something called a 401k. Now before you say “yeah I have that, I’m contributing,” listen to this. It’s not just about having a 401k; it’s about knowing how to use it. I’m Liz Mantel, and on today’s episode of Life Well Learned we’re gonna teach you just that, so when you retire you can become a millionaire.
Liz: Becoming a millionaire by the time you retire seems like a pipe dream, but it’s not—it’s gonna take some work and some basic understandings and that’s what we’re going to give you today; we’re going to simplify what a 401k is, not so that you know what it is, but that you understand how to use it. We’re gonna help make you a millionaire today. Now let’s get right to it, the basics—let’s take it all the way back: what exactly is a 401k? *soft guitar transition music*
Chuck Clark: A 401k is an employer sponsored savings plan.
Liz: This is Chuck Clark.
Clark: I am Assistant Professor of the Practice in the Business Management and Leadership Department at Medaille College.
Liz: So, the 401k is sponsored by your employer, but what exactly does that mean?
Clark: So, wherever you go to work they’ve got a number of investment options for you to save for retirement.
Liz: I think one thing that people get confused is the difference between a 401k and a pension.
Clark: A 401k is different from what you may know as a pension plan. Many of your older relatives or people who work even in government or teaching may have a pension plan, which is a defined amount based on your career earnings and years of service. What a 401k is, is an amount that you save on a percentage basis out of your paycheck, and it’s really more driven by you as opposed to a pension plan.
Liz: Face value, pension sounds pretty good—it’s the company’s money, not yours, so why isn’t that a thing anymore?
Kevin Connolly: The companies realize that this is a very expensive means of governing and also watching over, and it costs the companies millions of dollars.
Liz: This is Kevin Connolly; he is the CEO and Managing Partner of Buffalo First Wealth Management.
Connolly: In the 80’s, this man named Ted Benna came up with the idea of 401k, for people who had actually contributed rather than the company contributing to the total amount for retirement.
Liz: Ted Benna, the man Kevin is referring to, is known as the “Father of the 401k,” but it actually goes back a little more. In the early 1970’s, a group of employees from Kodak approached Congress and asked them to allow that part of their salary be invested in the stock market, and because it was coming directly out of their salary, they would be exempt from paying income tax on that portion. This request resulted in section 401-K being added to the tax regulations. It was then in the 1980’s that Ted Benna took note of the provision and figured out how to create a simple, tax-advantage way to save for retirement, and he called it the 401k.
Liz: So from that little history, we know that the 401k is employee-funded, which doesn’t mean that your employer can’t help, and we’ll get to that later. Let’s talk about the basics of contributing to a 401k. You’re gonna hear a lot of percentages, and that’s because typically people contribute a percentage of their paycheck, and when you’re asked to do that, you do have to figure out a few things.
Connolly: Do a cash flow analysis, understand where your cash has to go. You have to pay expenses, such as utilities, *typing on calculator sound effect* a car payment, a mortgage payment, a rent payment, figure that all out and see what you got left—that’s where you start. Don’t figure in when you go to Tim Horton’s, make your coffee at home. It may sound bad, but instead of that Tim Hortons cup, use a Thermos and make it yourself *coffee pouring sound effect* and you’re gonna start to see you’re going to have a lot of money left.
Liz: What Kevin is essentially saying is, you have to draw out a budget, and let’s be real: it’s going to be painful. You’re going to see how much you’re spending on stuff that really you do not need.
Connolly: You know a lot of us like to buy extra things. Say you want to buy songs, they charge you every month, they charge you $14 or $20, let me tell you something—that $14 or $20 starts to add up. I don’t care if it’s $20 a month, it may not seem like a lot but it is a lot. When you start adding it up and the number of years, you’re doing it just keeps coming out coming out coming out, *coins falling sound effect* there’s other ways to listen to music, and most important is, you’re starting to save. You can find a way to do it, you just have to be disciplined in doing it.
Liz: Okay, we did the painful thing, we put our budget, *writing sound effect* we’re cutting out the extras in life to save for our future, but still—how much should I contribute?
Clark: The basic answer to that question is, you should always strive to put in enough money to get your company match.
Liz: Chuck helped answer that question by bringing up another one. We’ve got to take it back a little bit before we move forward. Let’s talk about the company match in a 401k.
Clark: The employer piece of it typically is a percentage match up to a certain dollar amount. So, let’s just take a hypothetical example, let’s just say you put in 6%, because that’s what you feel your budget can afford, and let’s just use an average salary of $50,000 to use simple math, alright? On an annual basis, 6% of $50,000 means you as an employee would save $3000. So now the employer match piece of it—and again this varies by company, but let’s just say “Company X” will match, dollar for dollar, up to the first 3% of what you put in. That’s another 3% on your $50,000 salary, that’s $1500. That’s $3000 plus $1500 at the end of year one, you’ve got $4500 in savings, now that doesn’t account for any growth in your investments or anything, that’s just the dollar amount that you’ve invested after year one.
Liz: Essentially what Chuck is saying is that the match is free money from your company, so if you’re on the fence when you’re starting out about how much you should contribute, a good rule of thumb is to try and at least get to that matching goal, because at the end of the day if the match goal is 3% and you contribute 3%, you’re going to get 6%–it’s free money from your company. Now, free money from your company may sound too good to be true, but there’s a reason that companies do offer these matches.
Clark: Most of it is around employee retention and engagement, it’s just another form of benefit. When you combine it with health benefits, paid time off, other types of perks and amenities that companies give employees, it’s just another way of retaining and engaging a talented workforce.
Liz: Are you still with me? Do you understand the 401k yet? If not, its okay, we still have plenty to cover. We talked about the fact that you can contribute a percentage of your paycheck, and we’ve talked about the company matching it, but where are these funds going when you contribute them?
Clark: One of the things you’re going to find perhaps a little overwhelming in a 401k is the number of investment choices that you have available to you. Again, this is not an employer picking for you where they want the investments to go, it’s you deciding where you want both your money and the employer contribution to go.
Liz: So, the contributions you’re making are being invested, and hopefully invested well, because that’s how you’re going to become a millionaire, but how do you know which ones to pick?
Clark: Range of investments is from very very conservative, low-risk type of investments, to very very aggressive mutual funds that invest in both U.S and international companies, that are a little bit more aggressive high-risk, high-return type of things.
Liz: So, one way to go is to create and aggressive investment track, or a conservative investment track. Now, one way of thought is the younger you are, the more time you have to take that risk, and the older you are—you don’t want to mess with the money you already have, but there is another option.
Connolly: There are investments called target date funds.
Liz: This is Kevin Connolly.
Connolly: What that means is, say that you are going to retire in twenty years from now, your target date fund would be a 2040 fund, because in 2040 you are going to retire. The further the fund is out, the younger you are, and what that does is, it has different investments at different percentages that move with your age. The closer you get to retirement, the more conservative you’re going to be, and the less aggressive you’re going to be.
Liz: The target date fund can be summed up as the Goldilocks option; it’s just right for a novice investor that doesn’t want to be too aggressive or too conservative, but just know that they’re on the right path so when they hit retirement, they’re doing okay.
Connolly: The more risk you take, the more of a reward you may receive—and listen to what I just said: may receive.
Liz: It’s just up to you to decide whether the risk is worth it, but there are people who can help you with that. We’ll tell you who they are, and not only how the 401k helps your future, but can really help your present. That’s next on Life Well Learned.
*xylophone transition music*
Liz: As you’re listening to this, and we told you to at least try to get to the match when you’re contributing to a 401k, you’re still trying to figure out really how much you should be putting in. The 401k doesn’t just benefit your future, it actually can benefit you now—it can be saving you money.
Clark: Correct, there’s two ways to look at that, so the pre-tax piece of it, if you look at your paycheck every week, the amount that you’re putting into the 401k as an employee reduces the amount of pay in a given pay period that you pay taxes on.
Liz: Let’s break down what Chuck is saying a little bit more. At the end of the year, you’re taxed on what you made that year, but by contributing to a 401k, you’re actually lowering the amount of money you made in that year, meaning you’re going to get taxed less. Let’s go to Kevin for an example in terms that we can understand: money.
Connolly: Say you make $50,000 a year, and say your tax bracket at $50,000 a year is 17%, hypothetically—let’s make it even better, let’s make it $100,000, now your tax bracket is at 20%. Your tax bracket is going to be lowered, and if you’re at $100,000 and you’re over 50-years-old, you can contribute up to $26,000, so if you take $26,000 and put it in your 401k plan, your income is now taxed at not 100,000, but 74,000 so now you’re going to be taxed, and your tax bracket could be possibly lower, chances are it’s going to, so instead of paying say, 20% income tax, you’re going to pay 17% and that 3% could be a good amount.
Liz: So, the more money you put into your 401k, the potential is that at the end of the year you are paying less in taxes.
Connolly: That is absolutely, 100% correct.
Liz: So now you’re lowering the taxes you’re going to pay at the end of the year, but there is also another benefit.
Clark: The other aspect of tax deferred is you don’t pay any tax on the 401k amount until that future date that you retire, when theoretically you should be in a lower tax bracket and it’s a different tax structure
Liz: What Chuck is saying is that when you retire, typically you are pulling in a lower income, which means your tax bracket is lower, so the benefit of paying tax when you withdraw the money is that you’re going to be paying less tax on it. Let’s revisit the contribution question—how much should you be contributing to your 401k? Hopefully by the end of the episode you’ll know what is best for you, and you’ll know where to go to look for the answers, but keep in mind there is such a thing as contributing too much; there are limits, and one of the factors is your age.
Connolly: In 2019, the maximum contribution from you, an individual under 50-years-old, can contribute $19,000. If you’re over 50, you can contribute up to $26,000
Liz: So, why does someone over 50 get to contribute more, you ask?
Connolly: That is called a catch-up
Liz: What Kevin means by that is when you’re over the age of 50, you’re closer to your retirement age, meaning that you do not have that much time. So, let’s say you maybe started contributing later in life, they’re giving you time to catch up on those missed years.
Connolly: If you contribute to a 401k plan, you’ve got such an advantage and great power behind it, but the key is to start early, but there is never a time that you shouldn’t start.
Liz: Bottom line, is if you can—contribute to your 401k. And now, to really show you why, Kevin is going to break it down for you even more.
Connolly: I’m going to give you some statistics that will surprise you. If you start and you have fifteen years, and you contribute $5,000 into your 401k plan, after fifteen years with 8%, *money counting machine sound effect* you will have $146,621. Now that may sound like a lot to people, but now let’s keep going. If it’s twenty years, its $247,115, and after thirty years it’s $611,729, *cash register ding sound effect* that is contributing $5,000 a year which is very, very doable. Time, value, money. *stopwatch ticking sound effect* The more time you have, the more money you are going to make *coins falling sound effect*
Liz: Basically, start contributing as early as you can, because time is really the key to a 401k, and that is because of something called compounding.
Connolly: It’s the working of money, you usually invest every week or every two weeks, and produce growth in that particular account. Then on top of it, your funds in the 401k are constantly producing growth or dividends that help make the account grow overall.
Liz: In other words, you’re making money on your money. We’ve used 8% as an example, so if you invest $100 and make 8%, that’s $8. Now you’ve invested another $100 and made 8%, that’s 8% of not $100, but $208, that’s another almost $17, and over time, *bubbling sound effect* you start talking not about hundreds of dollars, but thousands, tens, and even hundreds of thousands of dollars. Again, using the 8% example, 8% of 200,000 is *jackpot sound effect* a lot of money. That is how your money makes money on itself, there’s a little more to it than that, but that is the basic explanation. Since we’re on this theme of time, let’s talk about when you can actually take money out of your 401k; it’s not like your checking account or your savings account, it’s meant for retirement, so if you try to take money out early, you’re going to get in trouble, *whistle blowing sound effect* back to Chuck.
Clark: There’s always various options where that rule could be relaxed, like if you’re a first-time home buyer, or for certain medical expenses, things of that nature, but you really need to consult a tax advisor based on your individual situation and where you are. As a general rule, the government and companies don’t want you spending your retirement money before it’s time.
Liz: Like Chuck said, there are exceptions to every rule, but the magic number is 59.5—that’s when you can pull money out of your 401k without being penalized. But, let’s say you’re under 59.5 and you need money for let’s say a car, let’s head over to Kevin Connolly with one of his real-world examples.
Connolly: Don’t take out to buy a car, oh boy don’t do that, alright? The reason for that is, you’re going to be hit with an early withdrawal tax, and that is 10%. So, here’s an example, the minimum taxable rate is 15% right now. If you took out of your 401k plan that amount, your income, okay, you’re going to be taxed 15% on that amount you take out, and if you’re under 59.5, add another 10—so that’s 25% in taxes you’re going to pay, and that will absolutely hurt somebody.
Liz: So, let’s say you do need money for something like a car, what should you do instead of pulling out of your 401k?
Connolly: When people come to me and say “hey I need to take out of my 401k plan,” and they’re young—say in their 30’s or 40’s, I highly recommend them say “Listen, please don’t do that. I can’t stop you, but please don’t do that. Go to a credit union, go to a bank, go to some place and take out a loan. Even if you’re paying 3% or 4% or 5% or 6%, it’s a heck of a lot less than 25%”
Liz: Long story short, touching the money in your 401k before you retire has to be your absolute last resort, but what does that mean if you switch companies? If the company’s sponsoring your 401k program, what happens to it when you leave? This leads us into the next part: the rollover. *magic wand sound effect*
Clark: One of the beauties of a 401k is that it’s portable, meaning that if I change jobs multiple times in a career, that 401k amount comes with me.
Liz: The money you put into a 401k is your money, and you get to take it with you—this is called a rollover, some people roll it over into their new 401k program at their new job, but there are a couple of other options, here is something that Kevin recommends.
Connolly: You can roll it over into an IRA. Why? Because an IRA gives you the flexibility of different types of investments. You’re going to be dealing with a financial advisor, they have a slew of different types of investments, it gives you an advantage. A 401k plan only gives you a certain amount of investments, so if you have the difference between maybe a dozen to twenty investments, versus thousands of investments, your advantage is the thousand because number one: cost, number two: performance, and number three: you have a better spectrum of opportunity.
Liz: Just remember, when rolling over your 401k it has to be rolled over into an approved fund so you’re not hit with that penalty. Keep in mind that your money is your money, but any money that the company matched, or maybe contributed on their own, could be withheld from the rollover. If you’re not vested, that money is technically still the company’s.
Clark: So vested is just a fancy term for saying for when that money becomes yours. Employer contributions, and again this varies by company, tend to have what they call a service time or a vesting time, so it might be anywhere from one to five years, or maybe you need to work a certain number of hours over a period of years before that money becomes yours. Let’s just say hypothetically, that there was a five-year vesting, it means that over a five-year period, 20% of what the employer puts in becomes yours every year, so 20%, 40%, and so on. At the end of five years, you’re 100% vested and forever vested until you leave the company.
Liz: To find out what your company’s vesting policy is, you should talk to your HR rep. Okay, do you feel any better about what to contribute into your 401k? I think basically the answer is, as much as you possibly can, but a great resource is a financial advisor. Like Kevin said earlier, IRA’s are a great option, but that’s a whole other podcast. Having a financial advisor might be the key to your success, you might think that only rich people have financial advisors, but that’s not true.
Clark: Everyone is different, everybody has a fingerprint, and there’s no two alike-fingerprints–it’s the same as working in finance and as a financial advisor. You have a financial fingerprint, you are different from everybody else, this is what is key to using a financial advisor, because he will customize a plan to your needs. Now, seeing a financial advisor isn’t just for the rich, it’s for everyone. You don’t need a million dollars to start with, you need to start some place in life, and that’s what a financial advisor will help you do. To start, and to get you through whatever you need in your life to reach your financial goals. Starting early will always help you succeed in trying to obtain your goals, but starting late, well, let’s put it this way—it’s never too late to start, so start saving immediately, and please see a financial advisor.
Liz: Hopefully we’ve armed you with the tools to really utilize the 401k to your advantage, and becoming a millionaire by the time you retire isn’t out of the question. Invest early, and invest as much as you can. I want to thank our experts today, Kevin Connolly and Charles Clark. You can learn more about them and maximizing the potential of your 401k at LifeWellLearned.org. Life Well Learned is presented by the Medaille Alumni Association, I’m Liz Mantel and we’ll see you next time.