LAST REVIEWED Apr 23 2020 13 MIN READ
By Damian Davila
For most Americans, maximizing an employer-sponsored 401(k) plan is key to a sustainable retirement. There are two reasons for this. First, the percentage of retirees relying on an employer-provided traditional pension as a major source of income went down from 33% in 2015 to 30% in 2016, according to data from the Employee Benefit Research Institute. In both years, only 27% of active workers expect a pension plan to be a major source of income during retirement. Second, while over 60% of retirees use their Social Security as a major source of income, only about one-third of active workers expect those monies to be a major source of income during retirement.
To help you make the most of out your 401(k) nest egg, let’s review different saving scenarios and their lessons for your retirement savings strategy.
Starting early vs. starting late
Let’s assume that you’re 20 years old, single, and making $30,000 per year. Assuming a 3% inflation rate, your plan is to retire by age 65, make your nest egg last for 20 years, and have a 75% income replacement rate throughout those 20 years.
With a constant 6% pre-retirement and post-retirement annual return for your 401(k), you would need to save 12.4% of your annual income to hit your target inflation-adjusted retirement income. For example, in the first year, you would need to save a total of $3,723 or about $310 per month and in the second year, you would need to save a total of $3,835 or about $319 per month.
If you were to stick to this retirement saving plan throughout all your working years, you would have a total 401(k) balance of $1,238,981 at the beginning of your retirement year!
If you were to wait just one year to start contributing to your 401(k), you would need to save 13.3% of your annual income, which amounts to $3,991 in the first year, to reach the same $1.23 million target at age 65.
401(k) Investment Lesson: The earlier that you start contributing to your 401(k), the higher your chances to reach your target goal. Not only you’ll need to contribute a small percentage of your annual income but also you’ll enjoy interest gains for a longer period of time. Use this retirement calculator to understand how small changes make a big difference.
High fees vs. low fees
Spending time looking for a fund within your 401(k) that shaves off 0.50% in investment fees may not sound worth your time. However, remember that your investment horizon for retirement is many decades-long and that those negligible differences will balloon to big amounts over that time.
For example, imagine that you’re age 30, have a $10,000 balance on your 401(k) with an annual return of 6%, and hold all of those monies in a target-date fund with an expense ratio of 0.96%. This means that your plan administrator would charge you $96 on the first year. For simplicity, let’s assume that you would pay to your plan administrator that $96 for 40 years until retirement age. By foregoing $96 per year for 40 years, you would lose on an extra $15,335.71 for your nest egg.
Instead, you could choose an index fund that charges you a much lower annual expense ratio, such as the 0.16% from the Vanguard 500 Index Fund - Investor Class (VFINX). For your $10,000 401(k) balance, you would pay only $16 in investment fees on the first year that you hold the index fund. Assuming that you’re able to keep the $80 annual savings ($96 in investment fees from target-date fund minus $16 in investment fees from Vanguard’s index fund) and that the index fund also provides an annual return of 6%, you would pocket an extra $12,780.40 for your 401(k) balance at the end of the 40-year period.
This example is a clear indication why the Department of Labor warns retirement account holders that excess investment fees and expenses could reduce your account balance at retirement age by as much as 28%!
Related article: Are My 401(k) Fees Too High?
401(k) Investment Lesson: Read Hidden 401(k) fees and What to Do About Them. The smaller your investment expenses, the more money that actually works towards your retirement fund. Review the expense ratios of the current holdings in your 401(k) and find out whether or not you have comparable investment options with lower expense ratios available.
Low contributions vs. high contributions
When it comes to saving for retirement and investing, money talks. When you’re able to commit a higher balance to your 401(k), you’ll unlock faster lower expense ratios and investment fees at several firms.
Here are two examples. Vanguard requires a minimum investment of $3,000 for its Vanguard 500 Index Fund - Investor Class (VFINX), which has an expense ratio of 0.16%. However, Vanguard only charges a 0.05% expense ratio to investors meeting the minimum $10,000 at the Vanguard 500 Index Admiral (VFIAX). That’s just $5 per year for a balance of $10,000! Fidelity uses the same strategy by charging a 0.09% expense ratio for its Fidelity 500 Index Fund - Investor Class (FUSEX, minimum investment: $2,500) and a 0.045% expense ratio for its Fidelity Index Fund - Premium Class (FUSX, minimum investment: $10,000).
And there’s more. First, check the fine print of both your 401(k) account and your investment account. Some investment firms may grant you access to lower charges for future purchases when you meet pre-determined total purchase thresholds. Second, when those living in your household or immediate family members invest in the same mutual fund, some companies provide cost breaks to encourage all of you to continue to do business with those companies. Third, some investment firms may grant you early access to lower fees when you sign a letter of intent binding yourself to meet a predetermined account balance by a specific date.
401(k) Investment Lesson: Read How Much Should You Put in Your 401(k). To unlock lower investment fees faster, bigger contributions are preferable to smaller contributions to your retirement account.
Pre-tax dollars (Traditional) vs. after-tax dollars (Roth)
There are two types of 401(k) plans: traditional and Roth 401(k). In a traditional 401(k), you contribute with pre-tax dollars, deferring taxation until retirement age when you’re most likely to be in a lower tax bracket. On the other hand, a Roth 401(k) requires you to use after-tax dollars only so all monies grow tax-free.
Let’s go back to our first example: you’re 20 years old, single, and making $30,000 per year. Assuming that your salary only increases 3% every year to catch up with inflation, you would only start making more than your desired income of $85,086 on your first year of retirement at age 56 ($86,948). In this example, it means that it might make more sense for you to contribute to a Roth 401(k) until age 55 and then contribute to a traditional 401(k) from age 56 until age 64.
Is this possible? Absolutely. All employer-sponsored Roth 401(k)s that match donations from plan holders must put those matching donations in a traditional 401(k). Or you could open a traditional 401(k) through a new employer or part-time employer or through your own business using a solo 401(k).
Learn more about your different 401(k) options:
401(k) Investment Lesson: Make sure to evaluate all of your 401(k) options considering your current tax bracket and that at retirement. Remember to revisit this decision every five years or so to make timely adjustments, if necessary.
Taking out a loan vs. not taking out a loan
That 401(k) loan is much more costly than you may think!
Let’s assume that you have a fully vested 401(k) balance of $40,000 and that your plan allows you to borrow from your balance. Here’s a financial analysis for the first year of taking out a $5,000 loan against refraining to touch your 401(k) balance:
|With 401(k) loan||No 401(k) loan|
|+ Investment return (7%)||+ $2,450||+ $2,800|
|+ Loan repayment||+ $5,000||N/A|
|+ Interest paid on loan (5%)||+ $250||N/A|
|- Origination fee||-$50||N/A|
|- Maintenance fee||- $25||N/A|
|= Balance one year from today||$42,625||$42,800|
In this scenario, you lost $175 just for taking out the loan on your 401(k). Keep in mind that we used the median values for the fees. According to the National Bureau of Economic Research (NBER), annual 401(k) loan origination fees and annual maintenance fees can go all the way up to $100 and $75 respectively.
Things can be even worse if you were to suddenly lose your job and be unable to pay back your loan within 60 days. In this case, your entire unpaid loan balance becomes taxable income, subject to federal, state, and local taxes and potential fines. Your nest egg would take a major hit and your tax bill for that year would increase.
401(k) Investment Lesson: Make your 401(k) a very last-resort for financing. There are many reasons why it doesn’t make sense to take a loan from your 401(k).
From these five 401(k) saving scenarios, it becomes clear that to maximize your nest egg you need to do more than just contribute a portion of your paycheck. Starting early, minimizing investment fees, maximizing contributions, taking into account current and future tax bills, and avoiding 401(k) loans should all be part of your retirement strategy.
Image credit: Roman Drits
Damian Davila is a Honolulu-based writer with an MBA from the University of Hawaii. He enjoys helping people save money and writes about retirement, taxes, debt, and more.