Lawmakers have a knack for clever acronyms, and the latest retirement legislation does not disappoint. It’s called the SECURE Act, which stands for Setting Every Community Up for Retirement Enhancement, and it’s aimed at helping Americans save for their later years.
One of the key goals of the SECURE Act, most of which takes effect Jan. 1, is to encourage more small businesses to offer 401(k) retirement accounts to their employees.
Small businesses provide 59.9 million jobs in the U.S., which is nearly half of America’s private workforce. And only about 28% of small businesses provide employees with a 401(k) plan. Lawmakers want to change that by offering enhanced tax credits to help cover startup costs for creating 401(k) plans. In addition, provisions will offer protections to small businesses that participate in lower-cost pooled employer plans effective in 2021.
As a result, more small-business employees should gain access to 401(k) plans over the next couple of years. And that’s a good thing. Access to a 401(k) with automatic contributions deducted from your paycheck puts your retirement savings on automatic pilot. If you’re new to 401(k)s, here’s how to use your account to save big money over time.
1. Max out the company match if available
The first question to ask about your 401(k): Does the plan have company-match contributions? These matching contributions are deposits funded by your employer. They usually equal your own contribution, up to a cap. If that cap is 3% of your annual salary, for example, you can contribute 3% from your paycheck and your employer will kick in another 3% at no cost to you. You can raise your own contribution above 3%, but your employer’s contribution won’t go higher than the cap.
Ideally, you should strive to contribute 10% to 15% of your salary in your 401(k). If you go lower than 10%, make sure you contribute enough to get the highest possible company match. In our scenario above, your bare-minimum contribution should be 3%.
Note that your contribution is taken out of your check before income taxes are calculated. So it doesn’t lower your net pay as much as you might think. Use a payroll calculator online to test how different contribution rates affect the size of your check.
2. Stay at your job
Job changes can disrupt 401(k) savings in two ways. Some 401(k) plans don’t allow you to keep your money in that account if you are no longer an employee. In that case, you should roll those funds over into an IRA. But almost one-third of job changers end up cashing out their balances instead. That windfall might be nice in the moment, but it’s the wrong move for your retirement planning. You’ll pay income tax plus a 10% tax penalty on that withdrawal. And worse, you’ve drained your retirement savings and you’ll have to start over.
A job change can also lead to the forfeiture of your company-match contributions. Most 401(k) plans have vesting rules, which specify how your ownership of those matching contributions increases over time. You might own 20% after your first year with the company and earn an additional 20% each year thereafter. After five years, you’d be fully vested, meaning the matching contributions are yours to keep. If you switch jobs before that five-year marker, you forfeit a portion of the company-match contributions, plus any earnings associated with those funds.
3. Invest in low-cost funds
Once you elect your contribution rate, you need to select investments. Don’t make the mistake of leaving your deposits in the account as cash — you have a much greater earnings opportunity by investing in stock market funds. As a point of comparison, cash interest rates might be as high as 2% before inflation. But the long-term return in the stock market is 10% before inflation.
Of course, your investment return from year to year will be higher or lower than 10%. But if you ride out the downturns, your long-term growth will exceed what you’d earn on cash deposits.
Even if you don’t know anything about investing, you can still do a reasonable job picking funds. First, look for funds that track a major index like the S&P 500. Or you could choose a target-date fund, which adjusts the risk level in the portfolio based on your target retirement year. Next, compare the expense ratios of your fund options. The expense ratio is a key performance indicator, and lower is better.
4. Increase contributions every year
Some 401(k) plans have an auto-increase feature that raises your contributions by a stated percentage each year. Use that feature if you can. You should also manually increase your contribution every time you get a raise. Serious savers will increase the contribution enough to offset the entire raise. And you can do this up until you hit the IRS-imposed maximum contribution limits. In 2020, the maximums are $19,500 (or $26,000 if you are 50 or older). Your company-match contributions do not count against these limits.
5. Don’t borrow or cash out
The final rule of 401(k) saving may be the most important. Do not cash out or borrow from your retirement account. In investing, it’s very difficult to make up for lost time. Say you pull $5,000 out of your account, but you pay it back over five years by contributing $83.33 monthly. Your balance after the five years, assuming a 7% growth rate, would be $6,064. But if you’d left the $5,000 in the account and made the monthly contribution of $83.33, you’d have $13,088 after five years.
Insuring your future
If the SECURE Act brings you access to a 401(k), try to start using it right away and increase those contributions aggressively. It will be slow going in the first few years, but eventually, as your retirement portfolio gains momentum, no one will have to explain what “secure” stands for.
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