I remember my first real job after my “brief” baseball stint post college. It was at Morgan Stanley. I vividly remember sitting at my desk the first week of work, excited to actually make money, but I had absolutely nothing to do. I was ready to work baby! Bring on some spreadsheets and whatever else I’m supposed to be doing here. I guess I’ll open this email from HR about my benefits and 401k.
What does vesting mean? How does this match thing work? How much should I contribute?
Unfortunately, people tend to put things off when they are unsure, which is what I did.
Let’s provide some clarity.
401k Contributions: Match or No Match?
If your employer provides a match:
- Contribute to your 401k plan up to the match. You can find out if your employer provides a match to your contributions by either asking HR or taking a look inside your employee benefits handbook under “401k Plan.” This is free money and something you need to take advantage of. A common matching arrangement is an employer will match 50% of the first 6% you contribute.
Example: You make $100,000 and contribute 6% to your 401k for a total contribution of $6,000. Your employer will match 50% of that, or $3,000. All in contributions for the year are $9,000.
- Once you’ve taken advantage of your employer’s match you can consider three different options:
- Contribute more towards your 401k plan with a maximum contribution amount for 2020 of $19,500. If your main goal is to save as much as possible for retirement, reduce taxable income, and cash flow is not a problem, then this might be the way to go for you.
- Work on paying down high interest debt. If you are carrying a balance on your credit card or have student loans you’d like to address, now is the time.
- Invest in a non-retirement account. Being an older millennial, you have 25-30 years until you can touch your retirement accounts without penalty (59.5 years old). Think about all of the expenses you’ll have before then: home purchase, kid’s college, vacations, etc.
If your employer does not provide a match:
- Choose between a Traditional IRA or a Roth IRA. Do you want to get a tax break now or down the road?
The benefits of an IRA over your employer’s 401k plan are that you have unlimited investment options and can often invest in a more cost-effective manner. Be aware of contribution, deduction and Roth IRA income limits that can help make the decision of which IRA is best for your situation. Need additional help finding out if you can contribute to a Traditional or Roth IRA? Check out this IRA Calculator.
- After maxing out an IRA, which in 2020 is $6,000 if you’re under 50 years old, consider contributing to your 401k. You might not be getting any match from your employer, but the contribution limit ($19,500 in 2020) is much higher and avails you the opportunity to lower your taxable income while saving for retirement.
*Every dollar you contribute to a pre-tax retirement accounts (401k, 403b, Traditional IRA, SEP IRA, SOLO 401k) reduces your taxable income dollar for dollar.
Example: You’re single and make $200,000 annually through your W-2 employer. Let’s assume 32% of your take home pay goes to taxes (it’s tiered, but for sake of example let’s assume it’s a flat tax). That results in you paying $64,000 in taxes each year, which leaves you $136,000 in your pocket.
You decide to contribute 5% of your salary to your 401k at work or a Traditional IRA for retirement. Five percent of $200,000 is $10,000, which goes into your retirement account. Since that $10,000 was contributed pre-tax, your taxable income is reduced to $190,000. Being in the same 32% tax bracket, you now owe $60,800 in taxes rather than $64,000, saving you $3,200 by contributing to your retirement account. So not only do you save $3,200, but you also contribute $10,000 to your retirement account. That’s a win-win baby.
What does vesting mean?
100% of the contributions you make into your 401k or employer sponsored retirement account are always yours. Unfortunately, it is usually not the same for the match that your employer contributes. It could take anywhere between 3-5 years before you actually own the money your employer contributed to your account, and employers use it as a way to keep you at your current company longer.
There are three main vesting schedules used:
Immediate – Just as the name implies, you immediately own 100% of the dollars your employer contributes on your behalf.
Cliff – You will own 100% of the contributions your employer makes after a specified number of years, not to exceed 3 years. So, if you leave before that date hits you won’t be able to take any of those employer contributed dollars with you.
Graded – With a graded vesting schedule the employee will gain ownership to a percentage of the employer contributed dollars each year. A common graded vesting schedule is you’ll own 20% each year for 5 years. If you leave before the 5-year time period, you’ll surrender the amount that has not yet vested.
Have a question? I’m here to help!
Fun Fact: Most airlines have a policy that the pilot and co-pilot of an aircraft are not allowed to eat the same meal in order to avoid the risk of both pilots suffering from food poisoning.
Disclaimer: This is meant to be general information and is in no way a recommendation for any investment product.