Americans on the whole have a terrible track record when it comes to saving money.
The St. Louis Federal Reserve pegged the U.S. personal savings rate at just 5.3% in June 2016. Amazingly, June's personal savings rate is more than 50% higher than what it was a decade ago, but it's substantially lower than that of other developed countries. In other words, Americans aren't saving much of their earned income, which means they're being forced to do more with what they have saved, and aren't always making the smartest investing decisions.
Is a 401(k) the answer for you?
But this isn't to say that the American worker doesn't have options. The 401(k) has become the most popular employer-sponsored retirement plan in the United States, with nearly 80% of all workers having access to a workplace 401(k) as of 2013 according to the Bureau of Labor Statistics. Based on Form 5500 annual reports released in 2010, 88.7 million people were actively enrolled in employer-sponsored 401(k)s, with total assets managed equaling $4.5 trillion as of the midpoint of 2013 based on Federal Reserve data. Mind you, this enrollment data is from 2010, and the total assets data is three years old, so we can only assume that participation and assets under management have moved notably higher since.
According to the Internal Revenue Service, the 2016 contribution limits for a 401(k) are $18,000 for workers aged 49 and under, and $24,000 for workers 50 years-old and above. This $6,000 catch-up clause, as it's known, is there to help more senior workers put a little extra away with retirement likely a decade or two away. Compared to the Traditional IRA or Roth IRA, which have annual contribution limits of $5,500 and $6,500 depending on whether you're older or younger than 50, one of the primary advantages of the 401(k) is its huge annual contribution limit.
Another 401(k) advantage is that money contributed is pre-tax dollars. The funds you allocate from each paycheck will be invested in your 401(k) before your earned income is taxed. This means contributions to your 401(k) can reduce your current-year tax liability, possibly putting more money in your pocket come tax time.
The 401(k) is also a tax-deferred plan. What this means is that as long as you don't make any unqualified withdrawals prior to age 59-1/2 (the first age at which withdrawing money from a 401(k) is allowed), your nest egg can grow without being taxed, which in turn can compound your gains. You will owe Uncle Sam his due when you begin making withdrawals during retirement, but your investments can grow tax-free while you're working.
A final positive for 401(k) plans is that quite a few companies match a percentage of their employees' annual earnings as a way to reward them, retain talent, and get their workers on the right path to a comfortable retirement. Not all companies offer 401(k)s, and those that do aren't guaranteed to offer company-matching contributions. But in those instances where a company does offer a 401(k) plan and matches a percentage of its workers' earnings, the match is often around 3%.
Here's what happens if you max out your 401(k) contribution
So, what might happen if you maxed out your contributions for a really long time? The answer is you'd wind up with an insanely large amount of money.
Let's imagine a worker began maxing out his or her contribution at age 25, and that he or she did so for a full 40 years, culminating in retirement at age 65. For our example, we're going to make the assumption that annual 401(k) contribution limits aren't going to change from $18,000/$24,000, based on age, even though we know these limits adjust higher every few years in order to keep up with inflation. For the sake of simplicity we're just going to assume a 40-year status quo. We're also going to assume a 7% average annual return for investments, which is the average annual return, including dividend reinvestment, for the stock market over the long-term. Lastly, we're going to hold off on factoring in the management fees associated with a 401(k). We'll get to those shortly.
If our fictitious worker were to begin piling $18,000 of his or her income into a 401(k) every year until age 50, and at age 50 began socking away $24,000 a year until age 65, he or she would have managed to nominally save $810,000. However, with those dollars compounding over time, our fictitious worker would wind up with (drum roll)... $3,744,207 after 40 years, based on the results of Bankrate's investment calculator! That should be more than enough for any American to retire comfortably. Imagine what would happen if you began maxing out your contribution at an earlier age, or even added two more years onto the back-end by working to age 67, which is the full retirement age for people born in 1960 and after.
Finer points to keep in mind
Maxing out a 401(k) can lead to a lot of money come retirement. But you'll also want to keep a few finer points in mind.
First, you should be aware of those aforementioned pesky management fees tied to 401(k)s. In addition to the costs tied to managing your money, mutual funds running 401(k) plans can charge bookkeeping fees, transaction expenses, legal fees, trustee fees, and plenty of other fees I'm not even mentioning here. Entreprenuer.com suggests that mutual fund fees can run up a cost of about 2% per year. This cost compounds right along with your investment gains, meaning you could be paying six-digits to mutual funds in fees over your lifetime when all is said and done.
Secondly, you'll want to be aware of the tax implications of a 401(k). As noted above, these are tax-deferred plans, meaning you'll owe no taxes until you begin making withdrawals. However, once you do begin making withdrawals, prepare to pay up. What's more, during retirement you're probably going to receive Social Security income, too. If you earn more than $25,000 annually as an individual, or $32,000 annually as a joint filer, some of your Social Security benefits could be taxed. Money withdrawn from a 401(k) counts as income toward this threshold. In short, your tax rate could actually move higher depending on how much you withdraw from your 401(k) each year.
A final feature to be aware of is that workplace 401(k)s are contracted with specific mutual fund providers, which means your investment choices can often be limited to a small handful of mutual funds, or perhaps up to a few dozen. The bright side is that you're often getting plenty of diversification this way, but if you're younger or more investment-savvy, you may be better off taking your chances with individual stocks, or at least having a broader array of investment choices to pick from.
Despite these finer points, a 401(k) can be a metaphorical and literal asset for workers come retirement. Perhaps it's time you considered maxing out your 401(k)?
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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