How much will my 401(k) be worth when I retire?
401(k) accounts are a core aspect of retirement savings for Americans today. In fact, 71% of American workers are offered a 401(k) compared to pensions. With nearly 90% of corporate pension plans vanishing since 1998, it’s clear that 401(k) plans are the standard and here to stay. But despite the growing importance of saving for retirement, most Americans are far from where they should be. The median retirement savings for Baby Boomers is only enough to consistently withdraw $6,000 per year! With such dismal savings, it’s time for everyone to get educated and get on board with the retirement savings movement.
What is a 401(k)?
Before going too far into the benefits of a 401(k), it is important to understand what they are and how they work. 401(k) plans are a tax deferred retirement savings plan created by the IRS code in section 401(k), hence the name of the account. The special tax rules of the account offer huge benefits to those willing to put in the savings and take advantage of the account.
Unlike regular earnings you receive through your paycheck, 401(k) earnings are not taxed the year you earn the money. Instead, your 401(k) savings are made with pre-tax dollars. This means while you don’t pay any taxes on the income the year you earn it, you do pay income taxes when you withdraw from the account during retirement. Presumably you will have a lower tax rate in retirement and therefore will save money overall on your 401(k) savings.
Each 401(k), or 403(b) for some education employees, plan is attached to a specific employer. Your employer creates the plan, works with an investment management company to administer the accounts and offer investment options, and in most cases even offers a match for employees who choose to contribute. This is essentially free money from employers and should never be left on the table!
Why should I contribute to my 401(k)?
There are several important reasons to take advantage of a 401(k) account. The primary benefits include:
- Tax advantaged retirement savings
- Employer matching
- Retirement focused investing
- Motivation to set funds away for retirement
- Savings are automated
The tax benefit of 401(k) plans should not be overlooked when deciding how to save and invest for retirement. If you are married and have a household income of $70,000 per year, your tax bill goes down by 25% of every dollar you contribute. If you were to save 10% of your income in your 401(k), or $7,000 over the course of a year, your taxes will be reduced by $1,750 at the end of the year.
Employers typically match around 3% to 6% of your take home pay, with certain requirements to make your own contributions to receive the match. Continuing the example above, a 4% match would be worth $2,800 per year. At this point, saving $7,000 for your own retirement yields you $9,800 in savings (including the employer match) and a $1,750 discount on your taxes. That’s a win-win-win!
While 10% of your pay may seem like a lot, experts today typically suggest saving at least 15% of your salary to maintain the same standard of living in retirement.
How much can you put in a 401(k) per year?
The IRS sets the maximum 401(k) savings rate each year. It is common for the total to stay the same or just increase slightly depending on economic conditions. For 2020, the maximum you can save in a 401(k) is $19,500.
Individuals 50 years of age and older are allowed to make an additional “catch up” contribution on top of the regular 401(k) limit. For 2020, this total is $6,500. The total savings limit for these individuals is $26,000 including both the regular maximum and catch up contribution allowance.
How do you calculate your retirement income from a 401(k)?
While savings accounts pay almost nothing today at most banks, 401(k) plans give you many more options. You can invest your 401(k) balance in a selection of mutual funds offered by your specific plan. If you are investing at the market average, using the S&P 500 as a benchmark, the market returns around 7% per year over time.
Depending on the investment options you choose and market conditions, your return may be more or less than the average, but it is the best measure when projecting 401(k) income in the future. Calculating income from a 401(k) requires projecting your future 401(k) balance including your current balance, planned savings, and your expected investment performance. Also remember to subtract any fees you expect to pay.
Next, you have a few options to calculate your return. Some investment experts suggest using the 4% rule to estimate your ability to withdraw without ever running out of funds. Multiply your ending balance by 4% to conservatively estimate your annual withdrawals in retirement.
Can you take money out of a 401(k)?
You are able to take money out of a 401(k), but there are rules to consider on the timing of your withdrawals. Withdrawing funds before you reach the government’s legal retirement age, you will have to pay penalties in addition to any taxes due. The current withdrawal age to avoid a penalty is 59 and ½ years of age or older. The early withdrawal penalty is 10%.
You also have the option to take a loan from a 401(k) account and pay it back at a later date, but this is a risky proposition and it is best to be avoided outside of a worst case scenario.
What happens when you cash in your 401(k)?
When you cash in your 401(k) in retirement, you will pay income taxes on the withdrawals you make. If your account is primarily investments, you will have to sell those investments in order to cash out.
The easiest option to cash in your 401(k) for current retirees is using an automated transfer on a schedule. Every week, every other week, or once a month you can have a direct deposit transfer from your 401(k) to your checking account just like a direct deposit from an employer. Just make sure you wait until you are 59 and ½ years old to avoid that additional 10% penalty.
What kind of investments are available in my 401(k)?
Every 401(k) offers different investment options. Some 401(k) plans offer low fee Vanguard funds that charge an average 0.18% in annual fees. Other employers choose higher cost 401(k) providers that charge well over three times that.
Popular investments in 401(k) plans include target retirement date funds, mutual funds with risk and investments managed towards a specific retirement age, and broad market index funds like S&P 500 index funds. Just beware of investing in anything too risky. This is your retirement and matching the market return typically offers plenty of retirement savings as long as you contribute regularly and save enough each pay period.
How can I increase returns in my 401(k)?
There are two ways to increase the returns of your 401(k) account. First is increase investment performance and second is minimizing fees. These problems can be simple to solve in some cases and nearly impossible in others.
First, consider the right investments when getting your account setup or rebalanced. Actively managed funds generally don’t perform as well as the market overall. If you can find low-fee S&P 500 index funds, you are likely in the best position for long-term returns. Even fancy hedge fund managers typically don’t beat the S&P 500 in the long run.
For fees, review all of your investment options. According to the SEC, a 0.75% difference in 401(k) fees will cost $30,000 for every $100,000 invested over a 20 year period. Learn more about maximizing your 401(k) returns in our detailed guide here.