For most people, a company-sponsored retirement plan, like a 401(k) or 403(b), is the main tool used to save for retirement. These plans are designed to make saving simple by combining easy payroll contributions, investment options, and valuable tax benefits. Many employers offer them as part of a benefits package. While every plan is different, the more you understand your options, the better you can take advantage of the benefits and build a strong foundation for retirement.
Pre-tax or after-tax contributions
All plans usually offer a pre-tax savings option while some only offer an after-tax (Roth) option. The pre-tax option helps you reduce your income and reduces taxes today. Once retired (and at least 59 ½ years old), any distributions will be taxed at your ordinary income tax rate. On the other hand, the after-tax option does not reduce your current income, but grows tax-free and is withdrawn tax-free in retirement.
Which type of contribution should you choose? It all depends, and the answer can get very complicated based on individual scenarios. In general, you would prefer to make after-tax contributions when you find yourself in lower tax brackets and utilize pre-tax contributions when you find yourself in higher tax brackets. True tax savings is realized when there is a significant differential between your current tax rate (when making the contribution) and the tax rate at the time of withdrawal.
There are many individualized scenarios, but here are a few questions you should consider when deciding between pre-tax and after-tax contributions:
- Do I expect my earning potential to increase over the course of my career?
- Is my (or my spouses) income higher or lower than normal this year?
- Will I move to another state in retirement?
- What other income sources do I expect to have in retirement?
- Is charitable giving in retirement important to me? (consider qualified charitable
distributions) - What tax bracket will my beneficiaries be in when they inherit the account?
How much to save?
If your company offers a matching contribution, always try to take full advantage of it. Usually, the match is set to a certain percentage. This percentage applies to your total compensation. If the matching contribution is 4%, and you earn $50,000 per year, you will be matched up to $2,000 of your contributions. If there is free money to be had by way of a company match, make sure you get it!
Beyond the match, the “right” savings rate depends on your lifestyle, goals, and financial situation. Online calculators can give you a general sense, but the best answer is personal. As an advisor, I help families prioritize and balance a variety of financial goals including retirement and periodically adjust as circumstances change. There may not be a perfect number, but one truth is universal: the earlier you start, the more time your money has to grow. The best time to start saving is now.
Investment options
Most plans provide a fixed menu of investment options. This list usually includes individual asset classes within the stock and bond market or target date funds. You can build your own portfolio by combining individual funds in a way that aligns with your risk tolerance and long-term goals, or you can choose the simplicity of a single target-date fund. Individual asset class funds will offer the greatest opportunity for customization. This is very useful if coordinating with non-retirement accounts and employing asset-location strategies. It could also be helpful if you prefer different proportions of asset class weights. While flexibility is useful, individual funds require a more watchful eye. You can set up automatic rebalancing if you don’t want your ratios of funds to stray too far from your desired target percentages. This should keep your overall risk at a consistent level. As you approach retirement, there is no automatic mechanism to reduce risk over time, and any necessary adjustments must be made manually.
On the other hand, target date funds combine individual asset classes for you in a thoughtful, well-balanced way. By choosing just one fund aligned with your expected retirement year, you get an investment mix that automatically rebalances and adjusts risk level over time. If you prefer not to manage rebalancing or make ongoing changes to your portfolio, a target-date fund can be an excellent, hands-off option.
Leaving your company
Once you retire or leave your company for a new opportunity, you typically have several options for your retirement savings. In many cases, you can leave the funds in your former employer’s plan. You may also choose to rollover the balance into a new employer’s retirement plan, or transfer it to an Individual Retirement Account (IRA).
The best choice depends on your personal circumstances, but a few key factors can help guide your decision. First, compare the costs. If your old plan offers low fees and strong investment options, keeping your money there may be beneficial. Second, review the investment options. Employer-sponsored plans generally offer a limited selection of funds, while IRAs provide a much broader range of choices. Understanding the differences can help ensure your savings remain well-aligned with your long-term goals.
Conclusion
Your employer’s retirement plan is more than just a benefit—it’s a cornerstone of your long-term financial strategy. Understanding how your contributions, investment options, and rollover choices work allows you to tailor the plan to your needs both now and in the future. Regularly review your plan to ensure it continues to align with your financial goals. With thoughtful planning and ongoing attention, your retirement savings can become a strong, dependable foundation for the next chapter of your life.
