We talk about the 401(k) match as the benefit most needed for investors to achieve the kind of retirement they need. We call it free money – which it really isn’t. We call it an incentive – which isn’t always the case. We call it a benefit worth considering – which it can be depending on how the employer gives it to you. A match in your 401(k) can be the deal breaker, particularly if the company you are working for has eliminated, reduced it or put all sorts of stipulations on the process.
While numerous companies allow you to begin to participate in your 401(k), some voluntarily, others through auto-enrollment, the match the company provides often lags behind. Even though about half of the businesses allow for immediate enrollment, only 40% of those will offer a match during those first weeks on the job. Almost as many make the new employee wait, often up to a year before they can begin using the plan.
Once that waiting period expires, the match may not be all that you hoped it would be. Companies still offer their own stock as a way to match employee contributions. But the vast majority offer only a 3% of your contribution. Coupled with the long wait period, the no-match or low matching contribution puts many workers behind the so-called and highly recommended early start.
(A note about stock contributions: These can be offered as a non-matching contribution or as part of a profit sharing arrangement. Either way, they don’t eliminate the need for the worker to begin using the plan. The wait period, the potential or fluctuating earnings of the company, and the pay rate all play into the eligibility of this sort of contribution.)
This doesn’t necessarily mean that the wait is worth it. Because many plans are small, offering few options, financially savvy employees may not opt to use it as much as they should. Less financially savvy investors tend to use it sparingly, barely reaching the invested requirements to receive the full match. The matching contribution may not even kick in until six to seven percent of your pre-tax income is committed to the plan.
Other companies opt for the fixed match. This requires the employee to contribute to the plan with the employer contributing fifty cents to the dollar until the 6% threshold is met. Some companies, about a fifth of those offering their employees a defined contribution plan do so in a tiered system of so much up to a certain level (for example, a dollar for dollar match up to say 3% and then fifty cents to the dollar on matches beyond that up to 6%).
The tier system in the example above acts as an incentive to invest more but often backfires when the employee doesn’t see the value in making the maximum contribution. The tier system can offer even more to the employee’s plan that the percentage system does – provided the employee sees the value of the plan and does some simple math.
Most workers don’t realize the importance of setting aside this six percent figure, worried that it will negatively impact their take-home pay. In fact, the nature of the pre-tax contribution will not alter your net pay all that much by making 5-6% contributions.
The bottom line is to use the plan as soon as possible, contribute as much as possible (using the 5% minimum as a guideline) and increase your contributions over time. I have become an advocate of the three tiered approach to investing your money.
First, contribute up to 10% of your income to your company’s plan. In this scenario, spread your risk out over several actively managed mutual funds across several sectors.
Then, as a tax hedge, open a Roth IRA. Use this to invest in a tax efficient index fund up to an additional 5% of your income. (When I suggest this as a tax hedge, I do so with the understanding that none of us will know how much our plans will be taxed in the future when we begin to withdraw them. This will allow you to have some pre-paid taxed retirement income. And because index funds trade less frequently and tend to pay dividends, the taxes on the gains will be more modestly impacted even if the rate returns to 20% at the end of the year.)
Lastly, once you have become comfortable with this allocation schedule, return to your 401(k) plan and chose a conservative fund focused on fixed income. The assumption here is that by the time you are able to do this, you are a little bit older and a little bit wiser about what your future will look like. It’s in our natures to run scenarios about this period in life and the older you get, the more you will need to balance risk with protection.
But invest. If you have to wait to get into your 401(k), open a traditional IRA, fund it fully and wait until the other plan is available. The clock is ticking, even if you think the alram won’t ring for another forty years. Waiting to begin investing can cost you thousands of dollars in potential future earnings.
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