This is part 1 of a series where I’ll be providing general education on many of the employee benefits elections that you’ll be faced with during open enrollment season. While there are some employers whose employee benefits open enrollment has already closed, many companies don’t have open enrollment until October or November. I find that many people take their best guess at making their enrollment elections, but have never really been well-educated on the decisions that they have in front of them or what might be best for their personal situation and don’t necessarily understand everything that they’re opting into or out of. Something that can make this even more confusing is having a spouse who’s employed at a company that provides benefits and trying to figure out how each employer’s benefits can work together for you. I’m hoping that this series of posts can help provide some education around some of the common benefits offered by employers and help people make better decisions for what might be best for their personal situation.
While enrolling in an employer-sponsored retirement plan such as a 401(k), 403(b), or 457b isn’t a decision that most people have to make during employee benefits open enrollment, it’s definitely a good time to consider making a change (or beginning to use the plan if you haven’t been) while you’re working through the other decisions that you have to make at this time.
Why Should You Use An Employer-Sponsored Retirement Plan?
I met with clients in their 70s last week who didn’t begin saving for retirement until late in their careers. Every time I meet with them, they tell me that the one piece of advice that they give to everyone they meet is to save for retirement as early as possible. While they’ve been able to transition to living a simple lifestyle that they love, they can also see how different things could be for them if they started saving when they first started working. I think you’re kidding yourself if you try in any way to justify saying that saving for retirement isn’t important or that you’ll be able to make up for it later.
The power of compounding returns is huge and something to be taken advantage of. Most of us aren’t going to have pensions available to us to pay for our lifestyles when we want to retire like our parents or grandparents which means that it’s going to be on us to figure out how to fund the rest of our lives once we stop working. I don’t know about you, but I don’t want to have to rely on Social Security to pay for my lifestyle when the time comes to retire. And I think that time (to retire) will come for most of us whether it’s because we simply don’t want to work anymore or it’s because we’re forced to stop working because we physically or mentally can’t do it any longer. I want the peace of mind that comes with knowing that I’ll be able to retire on my own terms when the time is right because I started investing early.
Employer-sponsored retirement plans provide three huge benefits (among others): tax-advantaged investing, employer matching contributions, and limited investment options. While there are many more benefits to these types of accounts, these are the three that I want to provide context around here.
Something to note is that money that you save into an employer-sponsored retirement plan is money that you shouldn’t expect to use until retirement. A retirement plan isn’t a savings account for short-term goals, hence the penalties for withdrawing the money prior to retirement. This goes for all retirement plans, not just those that are employer-sponsored. Money that you want to save and want to be able to access prior to retirement will better suit you in a high yield savings account or money market account.
Tax-Advantaged Investing
Depending on the options available to you and the type of account you invest in, different employer-sponsored retirement plans have different tax advantages. Typically, a retirement plan is setup with the ability to make traditional pre-tax contributions where you contribute to the account and don’t pay tax on that money today, invest it and let the money grow tax-deferred, and then pay ordinary income taxes on the money when you withdraw it in retirement. On the other hand, many more plans are offering the ability for employees to make Roth contributions where you pay the tax on your contributions today, invest the money and let it grow tax-free, and withdraw the money tax-free in retirement.
While you should go through the process to decide if you should be making pre-tax or Roth contributions, having the ability to make Roth contributions to an employer-sponsored retirement account allows you to contribute much more than you could to a Roth IRA and removes the income limits that come along with one.
Some people like to make 100% pre-tax contributions to save taxes today, some like to make 100% Roth contributions because they think they’re in a lower tax bracket now than they will be when they withdraw the funds in retirement, and some like to split their contributions 50% pre-tax and 50% Roth to have both options in retirement. There’s no perfect answer, but it’s always good to keep in mind that your employer’s contributions will be treated as pre-tax when you withdraw the funds. This could be a factor that plays into your decision of what type of contributions you want to make.
Employer Match
Many employer-sponsored retirement plans offer a matching contribution made by the employer to the employee’s account as an incentive. While these employer contributions could be on a vesting schedule where you become eligible to keep a certain % of the money with each year of service, it’s oftentimes a good idea to at least contribute enough to your retirement plan to receive the employer match. That’s free money that your future self will thank you for taking advantage of!
Limited Investment Options
I could argue this either way, and I think most financial planners would initially think I’m crazy for saying this is an advantage to an employer-sponsored retirement account without reading more into what I have to say.
As a financial planner, it can be frustrating when a client comes to me with a retirement account that has a limited selection of investment options and/or sub-par choices within the account, but I can see how it could be beneficial to someone without any investing knowledge and who doesn’t have someone to help them figure it out. There are so many investment choices available to us that the seemingly complex nature of investing for retirement overwhelms some people so much that they don’t even start. This is the reason that I think having limited investment options within a retirement plan could be good for the general employee who isn’t using a financial planner to help them make investment decisions.
Many retirement plans now offer target date funds which invest the employee’s money in an appropriate allocation that gradually adjusts based on a target retirement date. While these funds aren’t perfect, and there can often be much better alternatives, I think they can help people who feel overwhelmed with investing and can be a good place to start.
On the other hand, having limited investment choices within your employer-sponsored retirement plan could cause you to think twice about contributing more to the account than you have to to get the match. If you’re someone who wants to create a diversified asset allocation within your retirement plan, or use the asset allocation within the plan as a part of your overall portfolio, then having limited choices may mean that you’d be better off contributing enough to the plan to get the match and then contributing your additional savings to a Roth IRA, Traditional IRA, or brokerage account, depending on your personal situation and goals.
Savings Amount
It’s important to remember that you’re investing in these accounts for retirement. If you have a short-term need that you’re saving for, then this isn’t the place to do it. That money is better suited in a savings account where it’s not susceptible to the risk of the market. Also, there are penalties for withdrawing money from a retirement account early. With that being said, saving a significant portion of your income that you set aside specifically for retirement is probably a good idea, even if your employer makes a large contribution to your account.
If you aren’t saving anything to a retirement account right now, then start saving enough to get the match. If you’re saving enough to get the match, then consider contributing a little bit more. Even saving just 1% more per year can have a huge impact over the long-run, but you probably won’t feel a significant hit to your cash flow by doing so. Many retirement plans offer the option to have the amount that you contribute from your paycheck to the account automatically increased by 1% per year. This is an easy option to help decrease lifestyle creep, which is when you continue to spend each more as your income increases, and significantly increase your retirement savings over time.
Providing a general retirement savings rate for everyone to use isn’t a very good idea, but there are rules of thumb and data to help you make a decision and I think that generally most people should be saving more than they currently are. It’s always better to look at your savings as a % of your income rather than as a dollar amount. If you think of your annual savings as a dollar amount and your income rises but you continue to save the same dollar amount, then you’re saving a smaller % of your income.
For example, if you earn $50,000 and your goal is to save $5,000 per year (10% of your income) but you get a raise and earn $55,000 next year while still only saving $5,000, then your savings rate decreased from 10% to 9%. This can have a huge impact over the course of your career. Luckily, most retirement plans allow you to set a % of your income that you want to contribute to them.
Consider A Change
Most employer-sponsored retirement plans allow you to make changes in how much you contribute to them whenever you want. However, there are some which only allow you to do so a few times a year. Now is a good time to consider if you should start saving more to your account and/or if you should be making a different type of contributions (pre-tax or Roth) based on your current situation. Small changes that you make today can have a huge impact on your future.
