You work hard for your money, but there’s a certain part of your compensation that never shows up in your paycheck. If your company offers a retirement plan, the money that your employer contributes to that plan can play a critical role in your financial future.
There was once a time when employers would continue to pay long-time employs after they retired through the “defined-benefit” pension system. Those days are all but gone; today your employer might contribute toward your retirement savings, but he’s only supplementing the retirement savings that you’re doing for yourself. That means that you have to take responsibility for your future, and put a good plan in place.
Fortunately, there’s a lot of wisdom out there for planning a good retirement. Last time we talked about the Retirement Pyramid, which dealt with the roles that different financial strategies should play in your retirement plans. At the base of the pyramid is your company’s retirement plan. Making the most of your employers offerings will be a significant step toward building a great financial future.
Today, instead of setting up pensions for their employees, most companies help to provide for retirement through “defined-contribution” plans. This means that your company commits to contributing a certain amount of money toward your retirement savings each year. Most of the time, the amount that the company contributes is based on the amount that you contribute yourself.
There are a wide variety of company retirement plans out there, all with odd-sounding names like 401(k), 403(b) or SIMPLE IRA. Each of these plans has its own specific details, and the type that your company offers will be based largely on the size of the business and what sector of the economy it’s in. And while you can get the details of your own retirement plan from your company’s HR department, the specifics of the plan aren’t all that important for this discussion. While the numbers are different, the concepts are the same.
The basic principle of all of these plans is this: You’re going to save money for retirement by withholding some cash with every paycheck and depositing it into a retirement account (which usually comprises one or more mutual funds). This happens automatically — the company withholds the money from your check and sends it on to your investment bank. Along with that money of yours, though, your employer sends some of his own money to deposit into your account as well — that’s the company’s contribution. Those contributions are usually determined by matching the amount that you have chosen to withhold from your paycheck. Different plans allow employers to match at different rates, and up to different limits. In a SIMPLE IRA, for example, an employer matches the entire amount that you withhold, up to three percent of your gross pay.
In some plans, employers may not match the entire amount that you contribute, and some will match more than what you contribute — that all varies from company to company. But the most common plan is for employers to match everything that you contribute, up to the legal limit.
So, what role should your company plan play in your investment strategy? It should be the first place that you invest, and you should max out the plan to its legal limit. There are numerous reasons for this.
The first thing that makes these plans so great is the employer match. If you contribute $100 to your retirement savings, and then your company contributes another $100, you’ve effectively doubled your money right from the start. The company match doubles your investment power. While there are plenty of other great investment plans out there, none of them offer the immediate financial gain that comes with a company plan. That company match is a guaranteed doubling of your investment — a rate that you certainly won’t find anywhere else.
It’s important to take advantage of the company match as much as possible. True, in order to get the full amount of the match, you’re going to have to withhold some cash from your paycheck. And it can sting a little bit to give up the cash, but think of it this way: If you don’t max out your contribution to the retirement plan, then your employer won’t max out the company contribution. That means that you’re not getting the full compensation that you’re entitled to — you’re effectively working for less than you’re entitled to earn. So swallow hard, max out your contribution, and take full advantage of the match that your company offers. In the long run, you’ll be glad that you did.
There’s another benefit to these plans to: they’re tax-deferred. This concept can be a little hairy, but what it means is that investing in these retirement programs lowers the amount of your annual income taxes. If you earn $50,000 each year, but withhold $2,000 for your retirement plan, the government sees your income as $48,000, which means that you pay less tax. And in this respect, your employer’s contribution is considered free money — it’s compensation that doesn’t count as income, and you’re not paying income tax on it.
Tax-deferred plans have one downside: When you do retire and begin drawing on those accounts for income, you’re going to pay income tax on the money you withdraw. There are other retirement plans, like the Roth IRA, that allow you to withdraw money tax-free in retirement, and those should play a role in your investment strategy too. But the company plans are much better than simply buying stocks or bonds on the open market, where you’re using after-tax money and paying capital gains taxes on your earnings.
In your company’s retirement plan, the employer match provides an instant return on investment. And the government’s tax incentives make this an affordable and attractive way to invest for retirement. A good retirement pyramid will entail more than this, of course. But in almost every case, your company’s plan is the best place to start.
Photo by MIKI Yoshihito. Used under Creative Commons License.