Dave Ramsey’s Baby Steps Explained

Whereas Dave Ramsey’s Baby Steps have often been dissected one at a time, my goal in this post is to give an overview of the steps as a unit and explain why the order is essential. Hopefully, these steps can help you create a focused life plan for your finances, regardless of your age or […]

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7 Pros and Cons of Investing in a 401(k) Retirement Plan at Work

A 401(k) retirement plan is one of the most powerful savings vehicles on the planet. If you’re fortunate enough to work for a company that offers one (or its sister for non-profits, a 403(b)), it’s a valuable benefit that you should take advantage of.

But many people ignore their retirement plan at work because they don’t understand the rules, which may seem confusing at first. Or they worry about what happens to their account after they leave the company or mistakenly believe you must be an investing expert to use a retirement plan.

Let's talk about seven primary pros and cons of using a 401(k). You’ll learn some lesser-known benefits and get tips to save quickly so you have plenty of money when you’re ready to kick back and enjoy retirement.

What is a 401(k) retirement plan?

Traditional retirement accounts give you an immediate benefit by making contributions on a pre-tax basis.

A 401(k) is a type of retirement plan that can be offered by an employer. And if you’re self-employed with no employees, you can have a similar account called a solo 401(k). These accounts allow you to contribute a portion of your paycheck or self-employment income and choose various savings and investment options such as CDs, stock funds, bond funds, and money market funds, to accelerate your account growth.

Traditional retirement accounts give you an immediate benefit by making contributions on a pre-tax basis, which reduces your annual taxable income and your tax liability. You defer paying income tax on contributions and account earnings until you take withdrawals in the future.

Roth retirement accounts require you to pay tax upfront on your contributions. However, your future withdrawals of contributions and investment earnings are entirely tax-free. A Roth 401(k) or 403(b) is similar to a Roth IRA; however, unlike a Roth IRA there isn’t an income limit to qualify. That means even high earners can participate in a Roth at work and reap the benefits.

RELATED: How the COVID-19 CARES Act Affects Your Retirement

Pros of investing in a 401(k) retirement plan at work

When I was in my 20s and started my first job that offered a 401(k), I didn’t enroll in it. I was nervous about having investments with an employer because I didn’t understand what would happen if I left the company, or it went out of business.

I want to put your mind at ease about using a 401(k) because there are many more advantages than disadvantages.

I want to put your mind at ease about using a 401(k) because there are many more advantages than disadvantages. Here are four primary pros for using a retirement plan at work.

1. Having federal legal protection

Qualified workplace retirement plans are protected by the Employee Retirement Income Security Act of 1974 (ERISA), a federal law. It sets minimum standards for employers that offer retirement plans, and the administrators who manage them.

ERISA offers workplace retirement plans a powerful but lesser-known benefit—protection from creditors.

ERISA was enacted to protect your and your beneficiaries’ interests in workplace retirement plans. Here are some of the protections they give you:

  • Disclosure of important facts about your plan features and funding 
  • A claims and appeals process to get your benefits from a plan 
  • Right to sue for benefits and breaches of fiduciary duty if the plan is mismanaged 
  • Payment of certain benefits if you lose your job or a plan gets terminated

Additionally, ERISA offers workplace retirement plans a powerful but lesser-known benefit—protection from creditors. Let’s say you have money in a qualified account but lose your job and can’t pay your car loan. If the car lender gets a judgment against you, they can attempt to get repayment from you in various ways, but not by tapping your 401(k) or 403(b). There are exceptions when an ERISA plan is at risk, such as when you owe federal tax debts, criminal penalties, or an ex-spouse under a Qualified Domestic Relations Order. 

When you leave an employer, you have the option to take your vested retirement funds with you. You can do a tax-free rollover to a new employer's retirement plan or into your own IRA. However, be aware that depending on your home state, assets in an IRA may not have the same legal protections as a workplace plan.

RELATED: 5 Options for Your Retirement Account When Leaving a Job

2. Getting matching funds

Many employers that offer a retirement plan also pay matching contributions. Those are additional funds that boost your account value.

Always set your 401(k) contributions to maximize an employer’s match so you never leave easy money on the table.

For example, your company might match 100% of what you contribute to your retirement plan up to 3% of your income. If you earn $50,000 per year and contribute 3% or $1,500, your employer would also contribute $1,500 on your behalf. You’d have $3,000 in total contributions and receive a 100% return on your $1,500 investment, which is fantastic!

Always set your 401(k) contributions to maximize an employer’s match, so you never leave easy money on the table.

3. Having a high annual contribution limit

Once you contribute enough to take advantage of any 401(k) matching, consider setting your sights higher by raising your savings rate every year. For 2021, the allowable limit remains $19,500, or $26,000 if you’re over age 50. A good rule of thumb is to save at least 10% to 15% of your gross income for retirement.

Most retirement plans have an automatic escalation feature that kicks up your contribution percentage at the beginning of each year. You might set it to increase your contributions by 1% per year until you reach 15%. That’s a simple way to set yourself up for a happy and secure retirement.

4. Getting free investing advice

After you enroll in a workplace retirement plan, you must choose from a menu of savings and investment options. Most plan providers are major brokerages (such as Fidelity or Vanguard) and have helpful resources, such as online assessments and free advisors. Take advantage of the opportunity to get customized advice for choosing the best investments for your financial situation, age, and risk tolerance.

In general, the more time you have until retirement, or the higher your risk tolerance, the more stock funds you should own. Likewise, having less time or a low tolerance for risk means you should own more conservative and stable investments, such as bonds or money market funds.

RELATED: A Beginner's Guide to Investing in Stocks

Cons of investing in a 401(k) retirement plan at work

While there are terrific advantages of investing in a retirement plan at work, here are three cons to consider.

1. You may have limited investment options

Compared to other types of retirement accounts, such as an IRA, or a taxable brokerage account, your 401(k) or 403 (b) may have fewer investment options. You won’t find any exotic choices, just basic asset classes, including stock, bond, and cash funds.

However, having a limited investment menu streamlines your investment choices and minimizes complexity.

2. You may have higher account fees

Due to the administrative responsibilities required by employer-sponsored retirement plans, they may charge high fees. And as a plan participant, you have little control over the fees you must pay.

One way to keep your workplace retirement account fees as low as possible is selecting low-cost index funds or exchange-traded funds (ETFs) when possible.

One way to keep your workplace retirement account fees as low as possible is selecting low-cost index funds or exchange-traded funds (ETFs) when possible.

3.  You must pay fees on early withdrawals

One of the inherent disadvantages of putting money in a retirement account is that you’re typically penalized 10% for early withdrawals before the official retirement age of 59½. Plus, you typically can’t tap a 401(k) or 403(b) unless you have a qualifying hardship. That discourages participants from tapping accounts, so they keep growing.

The takeaway is that you should only contribute funds to a retirement account that you won’t need for everyday living expenses. If you avoid expensive early withdrawals, the advantages of using a workplace retirement account far outweigh the downsides.

How to Get Your Kid Started With Investing

Kid learning the basics of investing

My daughter recently lost $80 in her bedroom. It’s just gone. One theory is that we accidentally donated it to Goodwill, since she had stored it in an old book and we’d been clearing out a lot of junk. But it got me thinking: What would be a better place to keep money she’s not using?

She’s been bringing in some respectable allowance earnings with the chores she’s taken on recently. Plus, she always receives some money for birthdays, and she doesn’t spend much. Maybe an investment account?

While the investing rules are a little different for minors compared to adults, it’s not hard to get your child started investing. Even if they only make a little money, the experience may encourage them to start investing for retirement early in adulthood, which can set them up for life. Here’s how to show your kid the basics of investing.

Determine what kind of account to set up

Children can set up savings, checking, or brokerage accounts using the Uniform Transfers to Minors Act (UTMA) or the Uniform Gifts to Minors Act (UGMA). All they need is an adult (presumably you) to sign on as the account’s custodian. This means you have to approve what your child does with the money until your kid is of age, which is 18 or 21, depending on what state you live in. Because the funds or investments in a UTMA legally belong to your child, once they’re in this account, they can only be spent for your child’s benefit. You can’t deposit $100 in your child’s UTMA account and later decide you want it back or transfer it to another child.

Setting up a UTMA account is much like setting up any other account. You can walk into a bank or credit union and open one for your child by filling out some paperwork and showing your identification, or you can go online to sign up for one with a firm such as Vanguard.

Your child could also set up a UTMA 529 savings plan. The 529 is a college savings vehicle that has tax advantages, but also comes with restrictions on how it can be spent. More on that below.

Aside from a traditional brokerage account, your child could also try a micro-investing account, since they’re likely to be starting with a small amount of money. You can set up a custodial account through Stash or Stockpile — in fact, Stockpile even works with BusyKid, an app that helps families track kids’ chores and pay their allowances digitally.

Besides an investment account, you may also need to open a checking or money market UTMA for your child and link it to the brokerage account, as a way to fund the brokerage account and a place to receive dividends and other proceeds.

Unless they have earned income from working, your kids can’t set up a traditional or Roth individual retirement account. (See also: 9 Essential Personal Finance Skills to Teach Your Kid Before They Move Out)

Figure out what investment vehicles to use

Once their account is set up, kids have access to the same investment products that adults do, such as mutual funds, individual stocks, or exchange-traded funds. Which products they choose depends on their interests, how much money they have to start with, and how actively they wish to invest.

A child who is interested in following one or more companies in the news and making active investment choices may want to buy individual stocks. Look for a brokerage firm with no minimum initial deposit (or a low one) and low trade fees. While this is a concrete and exciting way to start understanding the stock market, make sure that kids understand that for the long haul, many financial advisers recommend investing in funds over individual stocks.

If your child doesn’t have any individual companies in mind, but would like to invest in the market as a whole, a mutual fund such as an S&P 500 index fund is a great way to go. Good ones have low expenses, meaning that your kid gets to keep more of his/her investment. Unfortunately, mutual funds do tend to require minimum investments. For instance, to buy shares in Charles Schwab’s often-recommended S&P 500 index fund, you need to open a Schwab brokerage account with a $1,000 initial deposit. However, there is one way around that: You can also open a Schwab account with a $100 deposit — but you have to deposit an additional $100 each month until the account has a $1,000 balance.

Your child could also buy exchange-traded funds, which work a lot like mutual funds but tend to have lower minimum investments.

Another way to get started with a small initial investment is to use one of the micro-investing apps mentioned above, which split one share of stock or of an ETF and sells the investor a fraction of it. These apps can make getting started very simple for young kids by characterizing investments by category. In exchange for making things this simple for you, these services usually charge a monthly fee; Stash’s is $1 per month.

While your child could also opt to invest in Treasury bonds or certificates of deposit, at today’s low interest rates, this probably wouldn’t be a very exciting way for them to learn about investing.

What about taxes?

Does your child have to pay taxes on their investment gains? Do they have to file their own tax return? The answer to both questions is, "It depends."

If your child’s investment income is less than $1,050, don’t worry about it; you don’t need to report this to the Internal Revenue Service. If the child’s investment income is less than $12,000, the parent can opt to report it on their own tax return, or file a separate return for the child. At more than $12,000, you have to file a tax return for your child.

What rate will your kid pay? Unearned income up to $2,100 will get taxed at between 0 percent and 10 percent, depending on what kind of income it is. After that, your child’s unearned income will be taxed at your rate, no matter if you file separately or together. So don’t imagine that you can save a bundle on taxes by transferring all your investment accounts to your kids — the IRS caught on to that gambit years ago.

If your child chose to put their money in a UTMA 529 plan, they never have to pay federal taxes (and generally not state taxes either) on the earnings, as long as they spend it on qualifying educational expenses, such as tuition and textbooks.

Will investing hurt their chances of getting college aid?

It’s important to note that when it’s time to apply for college financial aid, assets in the child’s name count against them more than assets in the parents’ name. Unless you’re sure your family won’t qualify for financial aid — and outside of the 1 percent, that’s not usually something you can be sure of in advance — encourage your child to choose shorter-term goals for their investment account. They could choose a goal of anything from buying a new Lego set, to a week of sleep-away camp, to their first car.

Again, putting their investments in a 529 plan changes the situation a bit. Even if the child is the account owner, the financial aid officers consider assets in a 529 account a parental asset. This is great, because only about 5 percent of parental assets count against financial aid eligibility, compared to 20 percent of student assets in a non-529 UTMA account.

If your student does invest college savings in their own name, have them spend their own money first before you tap into a 529 plan or any other savings you are holding for their education.

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Want to know how to get your kid started with investing? It’s a great way to help your children make money for the future. For personal finance tips here's how to show your kid the basics of investing! | #investing #personalfinance #moneymatters