Your Most Important Savings Mechanism

Saving for retirement is hard. luckily for most people in the US there is a tax advantaged way of contributing that requires little to no work from your self.

If you work for a large employer in the US there is a good chance you have access to a 401K retirement plan; this amounts to about 80% of all working Americans. However only around 40% of workers with access are actually contributing. Of those who are contributing the average balance is around $100,000 but the median balance is only just over $25,000. These numbers add fuel to the narrative that Americans are not saving enough for retirement.

Over the last 20 years or so the traditional pension scheme that gives people a percentage of their salary for each year worked has pretty much gone away outside of some public sector jobs. Instead the de facto way that companies want you to save for retirement is through a 401K scheme. This allows the employee to save up to $18,000 a year ($24,000 if over 50) into various mutual fund style vehicles before (and this is the key thing!) tax. So instantly you are automatically getting a 30% or more return on your money in that saving year. But wait, there’s more! Most companies will also match something like the first 3-5% of your monthly investment.

Note that although the money is invested tax free, when withdrawn (which you can’t do until 59.5 years old without a penalty) the money is considered normal income. However although you will pay taxes on it, the likelihood is your overall income is lower and hence your tax bracket.

So this is a powerful investment vehicle, you are saving tax free plus getting effectively a 3-5% pay rise from your business. However many Americans are still not taking advantage of it. Why is that?

Firstly I suspect it is because so many people are living pay check to pay check, hence the idea of reducing their monthly take home pay by 10% or more is tough. Secondly for younger people thinking about retirement is just not something they want to do, why save now for something that is 40 years or more away?

One of the nice things about 401K contributions is that because the money is coming pre-tax straight from your pay check you don’t even see the money, so it is never in your wallet. If this was happening straight from day one on your job you wouldn’t miss it. However participating in a 401K program is usually on an “opt-in” basis. You normally have to fill out a form if you want to participate and indicate how much of your monthly pay check you want to contribute. Would it not be better if it was opt-out, and you are automatically enrolled and you had to fill out a form if you didn’t want to participate?

This would probably rapidly increase contribution rates across the board. This is a classic definition of “nudge” behavior, a powerful force in economics (Richard Thaler just won the economics Nobel prize for his work on nudge theory).

The other problem in today’s society is that most people work many jobs and don’t stay in one place, if you lose your job it is very tempting to cash out your 401K, especially in a  time when you may be short of money. This should be resisted at all costs, and instead roll your old 401K into an IRA with an investment company such as Vanguard or Fidelity.

So are there any other pitfalls with a 401K? Most 401K plans will give you the option to invest in age based index funds so you can mitigate your own risk as much as possible. Many companies though still allow people to invest purely in company stock. This should clearly be avoided! You already have your income dependent on the performance of your work place, do you really want your investment dependent on the same company?

If you are not contributing to a 401K when you could be, rethink! If you cant max out the contribution, at least try to reach the level to get full company match. Maybe each year you can contribute a little more, take your annual increases and put those into your 401K.

The 401K is the bedrock of twenty first century retirement and if you can invest the full amount each year from your early twenties then maybe this will be enough to see you through retirement later in life. However for most people post tax saving will be required as well.

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Tax-deferred 401ks are bad for stock accumulation, because they convert what would normally be capital gains into ordinary income, thereby resulting in excess taxation. Better to accumulate in Roth 401k or in taxable brokerage accounts.