401K: Should I Participate?

If you are like most people, then you might feel like saving toward and planning for your financial future can be overwhelming.  It doesn’t help that there are a huge number of choices and decisions to make.  In this brief article, we’re going to explain one of the most common options that you have available to you now: the 401(k) plan.  

What is it: 

A 401(k) is a “payroll deducted” retirement investment account. This means the money you contribute to the plan is pulled directly from your paycheck and deposited into an account on your behalf.  The money is typically invested into mutual funds or similar investments with the hope that it will grow as you continue to work towards your retirement years.   

Often, if you choose to save into a 401(k) plan, your employer will offer a “matching” contribution.  This means that they’re kicking in additional money on top of what you’re choosing to contribute.  Who doesn’t love free money? 

How do the taxes work? 

You might be aware that a 401(k) plan can offer some tax advantages, so let’s briefly cover what those are.  We’ll take a deeper dive into these and talk some strategy in an upcoming article: 

Pre-Tax Account 

You can choose for your contributions to this account to be “pre-tax”.  This means that you won’t pay any federal or state income taxes on what you put into the account (you’ll still pay Social Security & Medicare taxes, however).  While you’re invested, the money will grow without being taxed.  When you start withdrawing the money from a “pre-tax” 401(k) account, it will then be taxed at ordinary income rates.  Importantly, “pre-tax” contributions will reduce your taxable income today, which should lower Federal & State income tax bills for most employees. 

Roth Account 

Many 401(k) plans have the option for “Roth” contributions.  These types of contributions are taxed before you put them in.  Just like the “pre-tax” contributions, “Roth” accounts are not taxed along the way as they grow.  However, at the end – unlike a “pre-tax” account – a “Roth” account can be withdrawn tax-free. 

Tax Deferral 

Both ROTH and Pre-Tax 401(k) accounts offer “tax-deferred” growth along the way.  What is this? Tax-deferral is simply the idea that as the investments grow along the way, they will not be taxed.  This is different than a regular savings or brokerage account, where your income & gains are taxed each year that they occur.  Tax deferral is a huge advantage to you the employee, because it produces dramatically higher ending balances for your retirement funds.   

Penalties 

A 401(k) is a long term, retirement account with special tax advantages granted by the IRS.  One of the trade-offs for having these tax advantages is that there are penalties for taking the money out too early.  In general, 401(k) money is not available for withdrawal until age 59 ½.  If you do withdraw the money early, you’ll normally face a 10% penalty plus taxes on the amount you take.  There are a few special exceptions to this, but as a guiding principle its best to assume the money you save into your 401(k) is tied up for retirement.

Should You Participate? 

As many employers offer a 401(k) plan with matching, the big question that many people ask is “should I participate? 

Since a company-matched 401(k) plan is essentially giving you free money, most employees are tempted to give a resounding “yes” answer to this question.  While that is probably the right answer for many folks, there are actually a few situations where you might want to hold off on participating, even if it’s just temporarily.

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When Shouldn’t You Participate?

Basically, if contributing to the 401(k) would cause you financial stress or if you’ve overextended yourself with debt, credit card payments, or other financial obligations, you might want to hold off. If any of those things are true for you, it’s probably more important to fix today’s cash flow issues before investing for your retirement.  A JarredBunch advisor can help you here. 

Furthermore, it’s also important to consider building an emergency reserve fund before investing in your company’s 401(k) plan. 

As a ballpark figure, we normally suggest having 3-6 months of cash on hand.  In translation: if you lost your job tomorrow, you would have three-six months to get back on your feet instead of piling on more debt or stressing about how to put food on the table.  Without an emergency fund, the next flat tire or illness could cause you to take on more debt, which then snowballs into a larger financial burden and more stress. 

Taking care of high interest debt is also vitally important. Just as interest on an investment account compounds, the interest on credit cards or loans compounds as well.  By paying down high interest debt before contributing to a retirement plan, you’ll lower your overall financial burden, improve your cash flow – giving you room to breathe – and, overall, you’ll be more financially secure. 

How Much Should I Contribute? 

As a guiding principle, we’ve found that most people should be saving 15% of their household income. We normally don’t want to save that entire 15% into a retirement account. You’ll want to consider whether you have adequate savings outside of your 401(k), and often we’ll want to divide that 15% savings between your 401(k) and other more “controllable” investments.  Remember, this 401(k) is a long-term investment and there are taxes & penalties if you take the money early.  This money is “locked up” for the long term. 

Ideally, you should contact one of the advisors at JarredBunch who can help you understand your individual situation and guide you into the right path for your retirement savings.

How Should I Invest?

There are normally two ways to choose your investments in a 401(k) – you can use a “Set it and forget it” option or you can select your own custom portfolio of investments from the investment menu. 

A “set it and forget it” option is a type of investment which is on auto-pilot.  Most 401(k) plans will offer a “target fund” as their default “set it and forget it” investment.  These types of funds are run by a professional manager with predetermined allocation intervals which will automatically adjust (from equites to bonds or a mix thereof) as you get closer to retirement.  

Your JarredBunch 401(k) has a second “set it and forget it” option – we have included prebuilt portfolios for you to use.  These portfolios maintain a certain risk level as you go along, instead of adjusting like target funds.   

If you prefer to invest in certain kinds of assets classes, economies or industries, you can build your own custom set of investments by using the investment menu provided in your enrollment booklet or in your online employee portal.   

And what about your investing style? You can be anywhere on the spectrum from conservative to aggressive in your investment efforts, with each carrying different corresponding levels of risk.  While more aggressive investments tend to have higher performance over the long-term, they also “move” more during market downturns, which can feel uncomfortable to a conservative investor. 

We have created a risk tolerance quiz to help you understand what kind of risks you’re willing to accept and what kinds you want to avoid. 

Investing aggressively is generally fine when you’re a several years from wanting to spend from this account.  For example, if you’re in your 20s/30s and are starting to invest in retirement, you have 30-40+ years to recover from any losses caused by a dip in the market. You have many years ahead to let your investments rebound and can even see a greater return if you continue to invest into the account while the investment prices are lower. 

On the other hand, if you’re close to your retirement age, it’s likely that a conservative approach may be more suitable. You might be tempted to make a mad dash for the finish line and try to end on a high note, but if a market correction comes at the wrong time, it can throw a big wrench into the gears of your plan. 

JarredBunch Advisors 

As part of your JarredBunch 401(k) experience, you have no-cost access to the expert advisors on our staff.  If you would like individual guidance on your situation, please reach out anytime.  You can call us at (855) 288-5588.

Not enrolled in your company's 401(k) plan?

Interested in reaching your full financial potential?