Company 401K plans are popular, accessible
retirement savings vehicles for most individual employees. A 401K plan allows
for workers to accumulate retirement savings by contributing a portion of each
paycheck before taxes are taken out, thereby letting one’s savings grow at a
higher, tax-deferred rate. Ultimately, taxes are paid once money is withdrawn
from the account. In addition to the tax-deferred benefits, employees usually
have an employer match program for the plan.
For example, the employer will match up to
50% of the first 6% that the employee contributes to the account. Consider the
funds from this employer match a “bonus” that is received each pay period and
contributed immediately to savings. Within each 401K account every company will
have its own list of pre-selected funds through which an employee can create an
asset allocation. If no action is taken by the employee, he or she will most
likely be automatically enrolled and begin investing contributions into a
Target Date Fund that corresponds with the employee’s expected retirement timeframe.
In other words, a typical career transcends 40 years so a 23-year-old employee
in 2015 would be automatically enrolled in the Target Date Fund that
accommodates an individual with an expected retirement year of, or around,
2055.
Target Date Funds function similarly to
Robo-Advisors* but automatically rebalance with an expected completion time
frame (i.e. the retirement date).
Conversely, Robo-Advisors have a perpetual time horizon like a pension
fund. Target Date Funds are the easiest asset allocation option for most
employees which offer the appropriate asset class exposure and professional
rebalancing. Alternatively, a more hands-on individual can design his or her
own asset allocation based on the fund options provided by the employer. Typically,
a company will have an array of mutual funds and ETF’s** in its assortment of
401K investment options.
Either way, whether one opts for an automatic
or manual asset allocation process the most important thing is to contribute
money to the company 401K plan and let it continue to grow over the market
cycles experienced during one’s career. In doing so, you as the employee will
help protect your purchasing power by investing in asset classes (e.g. stocks) that
have historically outpaced the rate of inflation as well as maximizing the time
value of money (i.e. the sooner money can be received and invested the better,
due to the compounding effect of interest).
Simply put, money earned at present
time is more valuable than the same amount in the future due to its greater
future earning capacity. Therefore contributing earnings automatically to a
401K plan will help you compound your earnings into a greater value come
retirement than an individual who started later. However, given this ubiquitous
concept in finance there are certain favorable 401K rules that allow for older employees
to contribute more to the 401K plan in a “catch up” manner.
In order to prevent any delay in 401K
participation, it is important that you receive adequate education on
retirement savings strategies so that a comprehensive investment plan can be
set up early and run automatically throughout your career.
As always, please do not hesitate to ask any questions. Thanks for reading.
JD
*Refer here to read my post entitled “How Does a Robo-Advisor Work for the Individual Investor?” to better understand this product.
**For additional information, ETF’s and
mutual funds are discussed in my post entitled “What You Should Know About ETF’s” and can be found here.
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