While the phrase “defined contribution plan” doesn’t sounds very exciting, it’s something that can really help you, and your family, reach your financial goals. In this article, we’d like to discuss one of the most common defined contribution plans - the 401(k). We will cover how they work when to start one, why they are beneficial, and some tips which can help Latinos as they consider the options which are available.
Let’s get started.
In the most basic terms, a 401(k) is an employee sponsored retirement savings account. The employee sponsored element is important - as this means that you and your employer will be contributing to the account on a monthly basis and your employer does most of the work managing the funds you are depositing. Employers have the option to offer these plans and on the same token, employees have the option on whether or not to participate.
In 2016, the Bureau of Labor Statistics estimated that 44% of all U.S. worked participated in some type of defined contribution plan within the workplace. The participation rate varies widely based on the type of job being completed.
|Type of Work||Participation in Defined Contribution Plans|
|Management, Professional, and Related||63%|
|Sales and Office||46%|
|Natural Resource, Construction, Maintenance||41%|
|Production, Transportation, Material Moving||44%|
Source: U.S. Bureau of Labor Statistics
With nearly half of all working Americans participating in some type of plan, why are these plans so popular? It is a combination of three factors:
- Invested funds are taken from pre-tax earnings
- Many employers offer a matching contribution
- Employers use these plans as a way to attract and retain top talent
Let’s explore each one of these items in a bit more detail.
Invested Funds Are From Pre-Tax Earnings
Before we get into the nitty gritty of pre and post-tax earnings, consider the options that are available to an employee who has access to an employee sponsored 401(k) and would like to begin saving for retirement.
- Option one is to take a portion of their after tax earnings and invest directly into a portfolio of stocks and bonds. This money will be after taxes have been paid on the earnings.
- Option two is to participate in their company’s 401(k) plan. The company takes a portion of the employee’s paycheck each month and puts it into a retirement savings account. All of this money is sent to the retirement account before taxes have been paid.
To illustrate the difference in these two approaches, consider the following example of two employees: Alejandro is managing his own retirement account and contributing funds after taxes (option one). Jorge is participating in his company’s 401(k) plan and is contributing funds before taxes (option two). Both employees are making $1,500 per month in pre-tax earnings, taxed at 25%, and contributing 10% of their earnings toward a retirement account.
Option one: Alejandro is paid $1,500 by the company and takes out 25% for taxes. He is now left with $1,125 in after tax income and sends 10% to his self managed retirement account.
In total, Alejandro sent $112.50 to his retirement account and owes $375 in taxes.
Option two: Jorge is paid $1,500 by the company and sends 10% of his pre-tax earnings to his 401(k) account. His contribution to the account is $150 and his taxable earnings for the month are now $1,350 ($1,500 - $150). He now owes $337.50 in taxes for the month ($1,350 x 25%).
In total, Jorge sent $150 to his retirement account and owes $337.50 in taxes.
As you can see, the difference in contributions is significant and can really add up over the course of one, five or ten years and this is the biggest reasons why employees opt to participate in employee sponsored 401(k). It is important to note that Jorge is not off the hook for these taxes, as he will have to pay taxes when he takes money from his 401(k) during retirement - we will cover this in more detail later.
Many Employees Offer a Matching Contribution
In addition to the benefit of making investments from pre-tax earnings, many employees offer a matching contribution. In most cases, this is capped at 3% of your pre-tax earnings. If we revisit the example from above, Jorge’s employer would have sent an additional $45 ($1,500 x 3%) to his retirement account during the month.
For this reason, when you decide to participate in a 401(k) program you are effectively getting a raise. In Jorge’s case, his employer is now paying him 3% more than they were before he joined the program. This is the second reason why these types of retirement plans are so popular.
Employers use these plans as a way to attract and retain top talent
As you can see from the examples above, these plans can provide serious benefits to Latinos who decide to participate in them. It’s for this reason, why many employers offer 401(k) plans as a way to attract and retain top talent. Historically, it was common for companies to offer pension plans, which provide a guaranteed stream of income for life to employees. As this approach has faded, the 401(k) has entered as a way for companies to provide retirement savings to employees while limiting the company’s lifelong payment obligations.
This is the third reason why defined contribution plans, specifically 401(k) plans, are so popular today.
When To Start
In short - as soon as possible. In a recent study by BankRate.com, nearly 75% of adults have regrets as it relates to their finances. The number one regret was not starting to save early enough. If you are young and just getting started, keep this in mind. Even if you can only put away $50 or $100 each month toward retirement the net result over a lifetime will surprise.
If you are older, and are feeling the regret of not having started early enough - it’s never too late to move in the right direction. Consider an ancient Chinese proverb:
“If you need shade the best time to plant a tree was 20 years ago. The second best time is now.”
Investment Choices and How To Use Your 401(k)
When you participate in a defined contribution plan, your money does not just sit in the account and accumulate. In most cases, the funds are placed into a portfolio of stocks and bonds. Most employees have two options when it relates to how these funds are allocated:
- Select individual stocks, mutual funds, and bonds they would like to invest in
- Set a target retirement date and use pre-built portfolios or funds from their plan’s administrator
If you are comfortable analyzing stocks and building investment portfolios, option one can be a great route. For the vast majority of Americans, this process can be daunting and having professional manage the process can be much needed assistance. Carefully consider your understanding of stocks, bonds, and your retirement plan before making individual stock, mutual fund, or bond investments with your 401(k) account.
Why NOT To Use a 401(k)
In this article we’ve talked a lot about why you should participate in an employee sponsored 401(k). Let’s address some of the reasons why you should NOT participate in a plan like this.
The biggest reason why Latinos do not participate is because they want their earnings now - rather than in 20 or 30 years when it is time to retire. If your budget is extremely tight and you need all of your earnings on a monthly bases to make ends meet, it might not make sense to send 5% or 10% into an account which you will not access for several decades.
Carefully consider your monthly budget, financial needs, and retirement time horizon. In general, if you have access to an employee sponsored 401(k) you should take advantage of it.
Paying Taxes on Before Tax Investments
In our previous example, Jorge was able to contribute 10% of his before tax earnings to his 401(k) account. Make no mistake about it, the government knows about this contribution and wants to get tax revenue from it at some point. When Jorge starts to take withdrawals from his 401(k) account these distributions will be taxed as ordinary income at the same tax rate as his paycheck. If this sounds a bit confusing, it’s because it is.
When it comes to getting the most out of your 401(k) account and minimizing the taxes on your withdrawals, we recommend consulting a financial professional. This is someone that can help you determine when, and how, to take withdrawals to minimize your tax liability.
What To Avoid
When it comes time to make any decisions regarding your 401(k) account, it is be wise to consult a financial professional. Not all financial professionals are created equal, and not all financial professionals are required to act in your best interest. To be completely honest, some financial professionals are closer to salesmen than they are to financial advisors. It’s never wise to leave your financial future in the hands of a self-motivated financial advisor who is working to meet a sales goal.
Look for a financial professional that is a Registered Investment Advisor (RIA), as these individuals are required to put your best interest before their own and generally provide the highest level of service to customers. As always, asking questions and determining how your financial professional gets paid is critical. We recommend working with fee-only advisors. These are financial advisors that get paid the same fee for providing financial advice regardless of what product or investment they recommend.
A 401(k) plan is a great way to begin saving and to secure your financial future. We hope you found this article insightful, interesting, and useful in your financial journey. At Super Monedero, we will be with you every step of the way.