Having looked at countless portfolios throughout my career, the first thing that strikes me about 401(k) plans is that this vehicle is the leading liquid asset owned by individuals. Anecdotally speaking, this fact is true for most people of varying affluencies, with the exception of multi-millionaires and the super-wealthy. Even then, large 401(k) balances frequently appear.
The Behavioral Phenomena Behind the 401(k)
There are probably many reasons for the popularity of the 401(k) plan, but this may be due to the fact that most people work for businesses or corporations where company retirement plans are an automatic benefit. Couple that with tax-preference treatment and a matching component, and you have a prolific investment vehicle.
1. Positive Peer Pressure to Participate
In that regard, there is a bit of a “keeping-up-with-the-Jones’” syndrome when it comes to individual investors. Often when socially discussing finances with friends and colleagues, the majority of individuals can demonstrate some knowledge of 401(k) plans. Those that cannot usually feel a pressure to learn more, which can help them in the long run. This is just one of those behavioral phenomena that work in a favorable manner.
2. “Follow the Herd” Mentality
Company retirement plans tend to be the starter savings vehicle for many (probably most) investors. Ease of access makes it an obvious choice; employees can easily sign-up when they complete their benefits enrollment, all in one go. Further, most people have a sense that saving through a company retirement plan is a good idea, since so many others do it.
3. Take the Path of Least Resistance
401(k) plans make it possible for investors to get on a regular and systematic savings schedule, which removes the inertia behind accumulating assets. Additionally, companies have streamlined saving for retirement by offering matching contributions, creating a “set it and forget it” mindset.
As we frequently counsel, it is strongly recommended to defer enough into your retirement plan to at least achieve the company match, since it can be considered a “free lunch.” On top of that, deferring salary is one of the few remaining tax deductions for most employees; earnings grow on a tax deferred basis, creating a “double-tax-preferenced” vehicle. These three factors add up to create an appealing channel through which to accumulate assets for spending later in life.
401(k) Contributions Best Practices
1. Do Your Homework
When evaluating the tax benefits of company retirements, tax rates do matter.
Rule-of-thumb: Use pre-tax contributions today while working and in a higher tax bracket, then distribute it later when retired and in a lower bracket to take advantage of rate differences. This general rule doesn’t always apply and making post-tax Roth 401(k) contributions is also a viable consideration.
Roth style accounts also provide for tax deferral on investment earnings, coupled with the certainty of tax-free distributions. While we can’t say for sure what tax rates will be in the future, pre-tax accounts often beat tax-free Roth accounts for those currently in high tax brackets.
2. It’s OK to Play Catch-up
There is also powerful math involved. Investors can start very early in their careers through regular contributions, then allow the compounding effect of investment returns to take over. Still, employees who start later in their careers can increase contributions and use the age 50 catch-up provisions to accelerate retirement savings. The key to accumulating large balances is to be committed and disciplined, understanding that time is your friend and that saving for retirement truly is a marathon-like endeavor. Further, holding a large percentage of investments in equities allows for the higher return potential that makes it easier to build wealth.
3. Monitor Your Wealth
It is important to be sure to monitor assets allocations, stay diversified, and understand the risks being taken through the investment options offered by the Company retirement plan. Individuals are tasked with funding their own retirement, and the 401(k) is the predominant account through which this is achieved. This is a retirement vehicle and funds should be allocated for spending far into the future and to avoid borrowing at a time in your life better spent pursuing your hobbies and passions.
In Summary
- The more years one enjoys eligibility and contributes to a plan, the better the chance an individual will achieve retirement success.
- Employee contribution rates should be at least enough to earn the match.
- Consider Roth 401(k) where appropriate, giving proper consideration to current and future tax rates.
- Use an investment strategy that is properly sized to one’s ability, willingness, and need to take investment risk.
- Don’t assume the government will take care of you – longevity, low investment returns, rising healthcare, and curtailment of social security benefits are all problematic for individual investors.
- If you have questions about investing or preparing for retirement, please contact your local Sikich wealth management advisors.
* Securities offered through Sikich Corporate Finance LLC, member FINRA/SIPC.
*Investment advisory services offered through Sikich Financial, an SEC Registered Investment Advisor.
