Waiting to Become Eligible
We receive a number of e-mails from workers who are upset that their new employer won't let them start contributing to the 401k plan right away.
These workers want to know what is the best way to keep saving in the interim.
When you start a job with a new company, there's a good chance you'll be in this situation. More than one-third (41.6 percent) of employers surveyed required workers to wait six months or more before they could participate in the 401k plan. Just over one-quarter (27.2 percent) had a one-year waiting period, the longest permitted by law, according to a study by the Plan Sponsor Council of America (PSCA).
So how do you keep saving for retirement? It's a very good question. In order to answer it, you need to first answer this one: Are you concerned about the lost tax deduction or the lost savings opportunity?
Your answer will help direct the strategy you choose to keep your savings program going. There are tax-deductible and nontax-deductible strategies.
The Cost of Missing
There's a good reason why you should think about the impact of interruptions on your retirement savings. If you don't, you could be hurting your future.
Missing a year early in your working career will have the greatest impact on your retirement balance because you will miss out on compound interest, said Bob Francis, president of corporate markets with ING-Aetna Financial Services.
"The front-end deposits (and growth on them) represent the biggest share of the ending account balance," said Francis.
Here's how compounding works. Suppose you're 25 years old and make a one-time contribution of $2,000 to a 401k plan with a 50 percent employer match. The total amount contributed would be $3,000. If you got an 8 percent annual return, in 30 years, the $3,000 would grow to about $30,000.
Now let's look at what that same $3,000 contribution would be worth if you made it at age 45. In 10 years, it would only grow to about $6,500.
Those numbers are a compelling reason to figure out a way to save.
If getting a tax deduction is your big concern, you probably have only one alternative: making a tax-deductible contribution to a traditional IRA. But, if you contributed to a 401k or other employer-sponsored retirement plan at another employer during the tax year, you can only make a deductible contribution to an IRA if you meet the income requirements.
Also, the maximum IRA contribution limit is $5,000 a year, well below the 401k pretax contribution limit of $17,500 for 2014.
Retirement experts interviewed for this article said that while a tax deduction is attractive, it's more important to make sure you don't stop saving.
"A concern I would have is the loss of (savings) momentum," said Elise Pilkington, assistant director of retirement and investor services with the Principal Financial Group, a 401k plan provider.
Workers who don't save regularly may find that the cost of their lifestyle rises to match their income. "Could you adjust if you jumped back in (to saving)?" she asked.
Here are strategies for maintaining your savings rate while you're waiting to become eligible for your 401k.
IRA: Contribute to an IRA. Anyone with earned income can contribute to an IRA. As explained above, if you participated in an employer-sponsored retirement plan at any time during the year, your income level will determine whether your contribution is deductible and to what extent.
Even if you can't make a tax-deductible contribution to a traditional IRA, you can still make an annual contribution of $5,000 to the account and take advantage of tax-deferred growth.
A number of retirement experts recommend that instead of contributing after-tax money to a traditional IRA, consider a Roth IRA, providing you meet the income limits. Here's why: Both accounts are funded with after-tax dollars (you can't deduct your contribution), and both accounts grow tax-deferred. The difference is that you won't have to pay tax on your withdrawals from a Roth IRA, if you meet the conditions, whereas you do have to pay tax on your earnings when you take withdrawals from a traditional IRA.
Double Your Contributions: Another possible strategy is to double your contributions when you finally can participate in the 401k. Here's how: While you're waiting to become eligible, open a savings account and deposit the money you would contribute to the 401k if you could. When you become eligible for your 401k, double your contribution, providing you stay within the contribution limits stipulated by the plan document. To make up for this drain on your income, gradually withdraw the money from your savings account.
The drawback to this strategy is that the money in your savings account won't compound over time, unless you can afford to leave it there while you're contributing double to your 401k.
Negotiate: You could ask your employer to compensate you for the lost savings opportunity. Some employers offer nonqualified plans that you might be able to contribute to. Or, you might be able to receive a bonus.
The drawback to this strategy is that it's often only for top employees. But, given today's tight job market, it may be worth a try.
Open an Annuity: If you think the $5,000 annual IRA contribution limit is too low, you could consider contributing to an annuity.
You use after-tax dollars to invest in an annuity but, like an IRA, all your money grows tax-free. You pay income tax on the earnings when you receive payments from the annuity. There is no federal maximum contribution limit, and the limits set by individual providers tend to be high.
But, you also have to consider that annuities generally carry higher fees than other investments because of the guarantees they provide.
Buy Growth Stocks: If you feel comfortable making your own stock picks, you could do what Virginia Morris, author of The Essential Guide to Your 401k Plan, recommends -- buy growth investments that you will own for 10 years or longer. "Don't look for stocks that provide income (dividends)," she urged.
Over time, hopefully the stocks will appreciate, and you only pay tax when you sell them. You will owe long-term capital gains tax, which for many folks will be less than their normal income tax rate.
If you opt for this strategy, you must be comfortable with the relatively high level of investment risk you will be taking.
Younger Than 21
Employees under 21 may have to wait longer than one year to become eligible to participate. Many 401k plans exclude these workers figuring that they will likely change jobs soon, which complicates administration of the plan.
If you're in this situation and want to start saving, try an IRA, Pilkington says. If you remain ineligible for the employer-sponsored plan for the entire tax year, you will be able to make a fully deductible contribution to a traditional IRA.
But, don't overlook the Roth IRA and the tax advantages it offers at retirement, Pilkington said. This may be even more beneficial; it depends on how badly you want the tax deduction now.
Other strategies listed in the section above might also appeal to you.
This is for educational purposes only. The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.