What You Need to Know About Your 401(k)

Millennial and Gen Z employees know the value of an employer-sponsored retirement plan. A recent survey by Betterment found that 79% of Millennials and 84% of Gen Z would leave their current job for one with better financial benefits. But when it comes to contributing, the numbers go down a lot. A Bank of America study found that only about 55% of Gen Z and Millennial employees contribute, and 70% of Millennials contribute less than $5,000 annually.

The Importance of Starting Young

Contributing to a retirement plan means reducing your available income. It may also reduce the amount you pay in taxes, but when you're at the start of your career, the tax benefit may not seem like it outweighs the loss of funds every month.

Early career also means high expenses, a high debt load, and lower total income to meet those expenses. It can be very tempting to kick the retirement can down the road and let 40-year-old you, with your student loans paid off and a bigger salary, handle the retirement savings load.

However, expenses tend to expand to the level of your income, so saving never really gets easier. But more importantly, saving even small amounts and investing over a longer period harnesses the power of compounding.

Let's assume you start at age 42 and save $500 per month. Assuming an 8% annual return, by age 65, you'll have accumulated $395,866, not accounting for taxes or inflation.

If you start at age 22 and save only $100 per month, under the same assumptions, you'll have $451,169 at age 65.

The value of saving early isn't just that you have a longer time to accumulate savings for retirement. You are also amassing savings that you can borrow from.

Borrowing From Your 401(k)

Your plan sponsor determines the rules for 401(k) loans, but you may be able to take out as much as 50% of the total value of the account. This 401(k) feature should only be considered in extreme situations where cash is needed in a real pinch. And I mean a real pinch. This feature should not be used to pay for that round-the-world vacation you've wanted for years.

Loan amounts are not taxable, and you won't incur a penalty on the funds. However, the loans are not open-ended; you generally have to pay them back, with interest, within 5 years of taking out the loan. If you default, you'll have to pay taxes and penalties – but the default won't impact your credit score.

The good news is that the interest you pay goes back into your account, along with the principal. So, while you are removing money from the investments you've decided on in your plan, and you will forgo any growth on the funds, you will get some benefit.

Retiring at 55 and Rule of 55 for 401 (k)

Since you've started amassing retirement savings early, you may have the option to retire early and not wait until you're in your 60s. However, 401(k) withdrawals before age 59 ½ usually incur a 10% penalty.

Per the IRS, the Rule of 55 enables workers who leave their job for any reason to start taking penalty-free distributions from their current employer's retirement plan once they have reached age 55. The plan works well for workers who want to retire early and those who require cash and thus tap distributions from their retirement plans sooner than is typically permitted. However, not all plan sponsors offer this option.

Normally, distributions from tax-qualified retirement plans, including 401(k) plans, before age 59 are subject to a 10% early withdrawal tax penalty. However, the Rule of 55 may enable an employee to obtain a distribution at age 55 and not be subject to the penalty for early withdrawals. A distribution would still be subject to an income tax withholding rate of 20%. However, if you owe less than you earmarked for the annual 1040 form, you will receive a refund after filing annual returns.

Another important consideration, the employee's funds must be kept in the employer's plan before withdrawing them, and the employee can only withdraw from the current employer's plan. If the employee rolls over the funds to an IRA, the Rule of 55 tax protection is lost.

Conclusion

Saving early and often in a 401(k) isn't just to ensure a good retirement 40 years down the road. You're creating a source of funds you can borrow from and giving future you the option to retire much earlier.

Are you trying to figure out what you should do to reach your retirement goal? At Pursuit Planning and Investments, LLC, I help you think through your options. I help you make the best decisions for yourself, your family, and your money. Feel free to place a commitment-free 30-minute meeting on my calendar. We can discuss your early retirement goal and begin best optimizing your financial plan in that meeting.

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