A 401(k) employer match is free money. Free money combined with the power of compounding is your chance to supercharge your retirement savings.
Many employers match your 401(k), Thrift Savings Plan, or 403(b) contributions. This means your employer contributes a certain amount to your retirement savings plan based on the amount of your own annual contribution.
Details vary from employer to employer. Some are generous while others aren’t. Some employers match a percentage of employee contributions, up to a certain portion of the total salary.
Note: I’ll refer to the term “401(k)” throughout this post but the information is applicable to Thrift Savings Plans and 403(b) plans as well.
Partial Matching
This means the employer will match part of the money that you contribute, up to a certain amount. A common approach is for employers to match 50% of what you put in, up to 6% of your salary. This means that an employer matches half of what you contribute but no more than 3%. To maximize your contribution, you should contribute 6%. If you put in more, let’s say 9%, they still only put in 3% because that is their max contribution. Compounding works both on your contribution and your employer match.
Look at the terms of your plan and if you have questions, ask your Human Resources.
Dollar-for-dollar matching
With dollar-for-dollar matching, or 100% match, your employer puts in the same amount of money you do, up to a certain limit. For example, an employer might offer dollar-for-dollar up to 5% of your salary. If you contribute 5%, then your employer puts 5%. If you put 3%, your employer matches 3%. If you put in 6%, the employer puts in 5% since that is the max.
Again, the terms depend on the company. Ask your Human Resources department for more information.
It’s wise to set this up as soon as you start your job so you don’t miss out.
Contribution limits
In 2021, the IRS limits employee’s personal 401(k) contributions to $19,500 a year ($26,000 if you’re over 50). Employer matching does not count toward this limit. The limit for both your contribution and your employer contribution is 100% of your salary or $58,000 ($64,500 if you’re over 50), whichever comes first.
Vesting schedules
Many employers have a vesting schedule associated with their 401(k) matches. This is to encourage employees to stick around and motivates employees to stay.
The vesting schedule depends on the company. If it’s a 4 year vesting period, your employer contributions vest gradually over the 4 years. After year one, you are entitled to 25% of the employer contributions. After year two, you are entitled to 50% of employer contributions. For year three, 75% of the employer contribution. And lastly, the employer contribution is 100% yours after 4 years. But if you leave before the employer match fully vests, you might give up some of this.
Whatever you contribute, is 100% yours and fully vested.
Why is this important?
Depending on your employer match amount, you can be earning 50 to 100% return on what you contribute assuming everything fully vests. If you invest in the stock market, your contributions plus the employer match can continue to earn higher returns and compound.
Financial Order of Operations
The following diagram provides a good reference for the order of operations to maximize your financial health.
Contributing the maximum match from your employer’s retirement plan should be a high priority – on the same level as saving for your emergency fund and paying off high interest debt payments.
401K / Thrift Plan / Retirement Part 2: What to Funds to Invest In
When someone starts a new job, he or she is inundated with forms to fill out and the retirement plan options can be lost in the shuffle.
Choosing what to invest in might be overwhelming but I like to keep it simple.
Assess your options. Every employer has different options. Assuming your employer has a retirement plan, see what the offerings are. Typical categories are:
- Target Date Funds
- Passively managed index funds
- Actively Managed Funds
When I started working, I had no idea what to invest in. I chose a Goldman Sachs Fund, Dodge & Cox Balanced Fund, and a WisdomTree Fund based on the charts and the name. My father was a high school teacher and my mother was a homemaker. I did not have a financial advisor so I had no one to ask for advice or guidance. I also wasn’t actively seeking this advice because I was focused on starting my job and my retirement plan was an afterthought.
Types of investments you may see in your retirement plan:
Actively Managed funds are run by managers who buy and sell stocks and bonds based on a fund’s strategy, performance expectations and market conditions. Actively managed funds aim to bring additional value to investors and try to exceed a target benchmark. Fund Managers are really intelligent people who use all sorts of analysis to run their funds. Actively managed funds have higher fees than passively managed funds because of the additional work and overhead. You as an investor pay research analysts and portfolio managers as part of an investment fee. Most of the time, these fees are taken out from your investment returns.
Passively managed funds aim to match, not beat, the performance of an index. Passive managed fund managers replicate a benchmark index, such as the S&P 500 index or Dow Jones 30, by choosing securities from that index and aim to match the returns of the index.
Since passively managed funds track and match the market, there is less day to day buying and selling of stocks and bonds. This results in lower costs which translates to lower expenses for the investor.
Target Date Funds are investments that are structured in a way to rebalance asset class weights to optimize risk and returns for a selected timeframe. In a retirement account, you choose the timeframe that is close to when you would like to retire and the fund is designed to gradually shift to a more conservative allocation to minimize risk when the target date approaches. Typically, as one gets older, a person should shift their allocations from stock (since they are risky) to bonds (since they are less risky). A target date fund is like autopilot where the fund rebalances and you as an investor don’t have to worry of adjusting your portfolio later in life.
So where do you invest?
According to SPIVA S&P Dow Jones, over a 20-year period, nearly 90% of actively managed investment funds failed to beat the market. Take a look at the annual scorecard. It’s pretty eye opening. Essentially, with most active funds, fund managers aim to beat the market and charge fees for their efforts, only to underperform the market. You might get lucky and find a fund that outperforms the market but the odds are against you. Why try to beat the market, when you can buy the market using passively managed index funds?
In 2008, the world’s top financial investors, Warren Buffet, challenged the hedge fund industry that hedge fund fees don’t justify the funds’ performance. Buffet placed a million-dollar bet with Protégé Partners LLC. Before the 10-year period was up, the hedge fund ended up conceding. Buffet proved that an S&P 500 index fund would outperform a carefully managed hedge fund portfolio over 10 years.
Assessing your options
When looking at your options, pay particular attention to the expense ratios on each of the funds. You’ll notice that the actively managed funds will be significantly higher — 0.5%-2.0%. This means, every year, part of your return is paid out to the managers and analysts running the fund, even if the fund loses money!
Passive funds tend to be much lower. The Vanguard Total Stock Market Index Admiral Fund (Ticker: VTSAX) has an expense ratio of 0.04% and Fidelity ZERO Total Market Index Fund (Ticker: FZROX) has an expense ratio of 0.00%. Compare that to active funds, Goldman Sachs Value Equity (Ticker: GSLIX) that has an expense ratio of 0.89%. An 1% fee might not sound like a lot but it’s pretty significant over many years.
Your best bet depends on your target asset allocation and what’s available to you through your employer. Look for a total market index fund with low fees and perhaps an international total market index fund. If you can’t, see if there’s a S&P 500 index or a target date fund that aligns with your financial goals.
Investing in a Traditional vs a Roth 401(k), 403(b), Thrift Savings Plan
Some employer retirement plans allow employees to invest in either traditional 401k/403b/Thrift Savings Plan or a Roth 401k/Roth 403b/Roth TSP. The difference between a traditional and Roth 401(k) is related to tax treatment and when you pay.
Differences between Traditional and Roth 401(k)
With Traditional 401(k), you contribute pre-tax dollars so you get a tax break up front, which helps to lower your current income tax bill. Your contributions and earnings will grow tax deferred until you withdraw the money. When you do withdraw, the withdrawals are treated as ordinary income and you have to pay taxes at the current tax rate.
With a Roth 401(k), you contribute after-tax dollars so you do not get a tax deduction. As long as you hold the account for at least 5 years, your withdrawals of both contributions and earnings are tax free at age 59 ½.
Traditional Vs Roth 401(k): What to pick
We can’t predict the future and know where taxes are going to be. You have to make an educated guess about where you will be in the future.
If you think your tax rate is going be higher in the future, it makes sense to invest in a Roth 401k. Roth 401k accounts are particularly a good choice for young professionals who are confident that they’ll be earning more and be in a higher tax bracket in the future.
Even if you think you’ll end up in a lower income tax bracket during retirement, your withdrawals from your traditional retirement account could push you into a higher tax bracket.
If you plan to have a pension, it might make more sense to contribute to a traditional 401(k) as the pension income in retirement may push you into a higher tax bracket.
There’s lots of unknowns and you don’t have to put all your money into one of these accounts. If your plan allows it, you may want to split your contributions between the Traditional and Roth.
Notes
Similar to a traditional 401(k), a Roth 401(k) requires you to take a required minimum distribution (RMD) from your Roth 401(k) when you retire. In 2019, the SECURE ACT raised the age for taking the RMD to 72.
In 2021, Congress is actively debating the tax treatment for retirement accounts. Under the current laws, a person can avoid a RMD on a Roth 401(k) by rolling it over into a Roth IRA account. There are additional factors to consider such as potential fees and legal aspects.
Increase contributions over time
Let your account value build over time as you and your employer match contributions compound. As you advance in your career and your paycheck increases, continue to increase your contributions to your employer retirement plan.
Summary
This post focused on the 401 k employer match and provided an overview of how to maximize your employer match and why it is important.
