Nest Egg Building
Passing up the immediate gratification that comes from taking home a higher paycheck may be a no-brainer when your employer is giving you free money as part of the bargain, but should you consider deferring more than the amount necessary to get the full match? To tackle this issue we recommend, if at all possible, actually using a brain (yours, preferably) because now there might be some slightly harder choices to make.
Under law, the maximum amount that you can defer into a 401(k) plan is $14,000 (in 2005). Under most plans there is also a percentage limit, usually about 20% or 25% of your salary. Therefore, if you earn $40,000 a year, and your employer allows deferrals up to 20% of your salary, your potential deferral would be capped at $8,000. If your salary were $70,000, the cap would move up to the $14,000 maximum permitted under law.
For many people, deferring every dollar that they can afford through a 401(k) plan will make a lot of sense. But what if you feel that you can do better investing outside of your 401(k) plan? After all, there are hundreds of thousand of words written every day around Fooldom on how to beat the market returns, and here we are saying that the choices in your 401(k) plan are very unlikely to provide a real opportunity to outperform the market.
As explained before, the advantage of participating in your 401(k) is that you defer paying taxes for years on the deferral amounts. If, for example, you earn $30,000 per year and contribute 5% of your salary to a 401(k), you would save about $225 a year in taxes. That $225 a year is money that you're investing, rather than giving to Uncle Sam.
Additionally, your investment earnings are growing under a tax-deferred status. To achieve the same results by investing after-tax money that you would achieve with pre-tax money matching the historical returns of the S&P 500 Index, you would need to realize annual returns of well above 11%.
Even if you do believe that there are ways to invest your money that might outperform the returns of an index fund in a 401(k) plan, you should, in the words of the Delphic oracle, "Know thyself." Are you somebody with the discipline to follow through on good intentions? The beauty of the 401(k) deferrals is that you not only are making regular investments, but you do so automatically, every paycheck -- before you have a chance to touch, smell, taste, or roll around in that money. For many, that alone will ensure that their retirement funds are accumulating in a better manner than if active work were involved to invest the money after cashing their paychecks.
One other tax-deferred plan to keep in mind when setting aside money for deferrals is the Roth IRA. Making sure that you save enough to make a full $4,000 a year contributions to a Roth IRA is always a good idea. The advantage to the Roth IRA is that once you've put money into it, you won't ever have to pay taxes on the earnings. While 401(k) contributions avoid taxes at the beginning and defer them until later, the Roth IRA allows all of your investment income to grow without incurring any tax liability whatsoever. The other advantage to the Roth is that if you've opened up an account that doesn't charge you any money in annual maintenance fees, you're actually doing better than you would with the same amount in a 401(k), because most 401(k)s do charge slight (but important) fees on your savings.
That's right. There are fees everywhere, and just as mutual funds within a 401(k) plan charge an annual management fee, the 401(k) plan itself is tacking on charges that your employer (or more likely you) are going to be paying every year. How to keep those fees under control is the next to the last step you need to know before you can stop worrying about what to do with your 401(k) plan savings.