“You can become a 401(k) millionaire,” my husband and I
recently told our 26-year-old daughter.
That statement perked her up and helped us start a
discussion on contributing to her first 401(k). It’s a conversation we’ve been
eager to have since she started working full-time.
After getting her undergraduate degree, our daughter Olivia
decided to go straight to graduate school to get a master’s in social work.
Once she completed her studies, she worked for a nonprofit in a low-paying
internship for 14 months. She started her first full-time job earlier this year
and — after a probationary period — she is now eligible to contribute to her
company’s workplace retirement plan.
Although we’ve been having preliminary talks about her need
to save right away for retirement, this was it — her first 401(k). Once she
received the information packet, my husband and I sat down with her to figure
out how much she should contribute to her retirement plan.
Our talk involved four major questions she had about this
next phase of her financial life.
Should I take full advantage of my employer matching
contribution?
How much should I contribute from each paycheck?
Should I invest in a traditional 401(k) or Roth 401(k)?
How should I invest my contributions?
First up, we discussed her company’s matching contributions.
Should she contribute enough to get the full match?
It was a resounding “yes” to this question.
In her case, her firm offers the most popular 401(k) match
formula. Fidelity Investments says the most common formula is a 100% matching
contribution for the first 3% of an employee’s contribution and then a 50%
match for the next 2%. Under this formula, a 5% employee contribution of $100
would be eligible for an $80 employer match, Fidelity points out.
This was an easy sell for our daughter. She saw the wisdom
in not leaving money on the table. Fidelity looked at the 401(k) millionaires
in the plans the company manages and found that if there’s a company match,
these investors take advantage of it. The most successful investors in
workplace retirement plans always contribute enough to get the full match during
their careers.
Next: Could she afford to push herself and contribute more
than what it took to qualify for the full company match?
This was a harder sell. But in the end, Olivia decided to
save 10% of her salary. And she can, because she has chosen to live at home,
something her dad and I wholeheartedly encouraged. It’s a smart money move for
young adults who have this option. We agreed not to charge her any rent if she
saved aggressively. (Plus, she doesn’t have any student loans because of the college
choice she made.)
Fidelity Investments says that many employers are designing
their company retirement plans to help their workers save more by using
auto-enrollment. The most common default savings rate for auto-enrolled
employees is 3%, according to Fidelity. But a growing number of companies are
pushing this rate up. One in five employers auto-enrolled employees at a 6%
savings rate in the first quarter of 2021, Fidelity said.
Of course, workers can opt-out or set their own lower rate
of contribution.
I was amazed that our daughter’s company automatically
enrolls new employees in their 401(k) with a default contribution rate of 10%.
For many young adults, saving that much might not be
possible. But in Olivia’s case, she could stretch because she plans to live
with us for some time, which allows her to keep her expenses low, freeing up
more money to invest.
We also pointed out that her employer match of 5% combined
with her 10% contribution, would put her at the 15% contribution level that
Fidelity recommends for retirement savers.
Then there was the decision about which type of retirement
plan to utilize. Her company offers a traditional 401(k) and Roth 401(k).
The difference between a traditional and a Roth 401(k) comes
down to when you pay the taxes. With a traditional 401(k), your contributions
are made with pretaxed dollars. You pay income taxes when you withdraw your
funds. With a Roth, the taxes are taken out upfront.
I suggested she follow the advice of Carrie
Schwab-Pomerantz, president of the Charles Schwab Foundation and a fierce
advocate for financial literacy.
Typically, Schwab-Pomerantz wrote in a blog post, “upfront tax
deduction of a traditional retirement account is less valuable now than the
tax-free withdrawal of a Roth down the road.”
Olivia went with the Roth.
Finally, we talked about how to invest her contributions.
Because she has plenty of time until she wants to retire — her goal is age 55 —
she opted to invest aggressively, mostly in stock mutual funds.
Starting with her next paycheck, our daughter is now well on
her way to building a secure retirement.
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