Greetings! I wanted to provide some information to help investors allocate strategically for the long-term. 401(k) plans are an important topic in regards to long-term investing.
Wall Street Journal defines a 401(k) plan as, “a retirement savings plan sponsored by an employer. It lets workers save and invest a piece of their paycheck before taxes are taken out. Taxes aren’t paid until the money is withdrawn from the account.”
Employees make salary deferral contributions which are usually pre-tax, unless a Roth option is offered.
With a 401(k) plan, each participant is in control of the investment elections. Most plans offer a variety of mutual funds composed of stocks, bonds, and money-market investments. Another popular option offered in 401(k) plans are target-date funds. Target-date funds contain a combination of stocks and bonds, which are managed to become gradually less aggressive as one nears retirement age.
The current contribution limit for 401(k) deferrals is $18,000 in 2016, and participants age 50 or older can contribute an additional $6,000 annually. This extra payment is known as the catch-up provision.
401(k) plans can be very powerful when it comes to long-term investing. Many employers offer a match on a participant’s 401(k) deferrals, up to a designated percentage. A common format for many plans is a 100% match on the first 3% of deferrals, and a 50% match of the next 2%, for a total employee contribution of 5%. If a participant wanted to achieve the full match of 4%, then he or she would need to contribute 5%.
A wise investor should always contribute the amount necessary to receive the full match. The match is essentially free money, that you otherwise would have never had! Employers develop matching provisions as a retention tool for their employees.
Another important aspect of investing in a 401(k) is that it allows an investor to dollar-cost-average their purchases of investors within the plan. The concept of dollar-cost-averaging refers to buying a particular amount of an investment on a regular schedule. The schedule is usually closely aligned with payroll dates. More shares are purchased when prices are low, and less shares are purchased when prices are high. This strategy lessens the risk of investing a large amount in a single investment at the wrong time. When you are contributing to a 401(k) plan on a bi-weekly payroll schedule, purchases are being made every other week at different prices than the prior purchases.
Many 401(k) plans also offer loans within the plans. If a participant is in a difficult situation and needs more money, they can borrow from themselves in their 401(k) plan. The interest that is repaid on the loan is being paid back to yourself. Due to the interest repayment, the borrowing cost is essentially alleviated. Receiving a loan from a 401(k) plan is not a taxable event, unless loan limits or repayment schedules are violated.
However, most financial professionals would advise to utilize a 401(k) loan only under dire circumstances, as this can impair retirement planning.
In summary, utilizing the 401(k) offered by your employer is very important to a long-term investing strategy. An employer 401(k) match, dollar-cost-averaging, and the opportunity of taking out a loan, are all wonderful benefits of a 401(k) plan. I hope that our clients are utilizing their 401(k) plans in the most effective manner. We are always here to help! Until next time, Happy Investing!