How to generate income inside of your 401(k) for retirement

401(k) plans are retirement savings vehicles offered by your employer and the plan’s service provider (a financial institution like Fidelity Investments, Charles Schwab or Vanguard to name just a few). You are restricted in your investment choices to those that are offered by the service provider – typically mutual funds or ETFs. You determine how much you want to divert from your salary into your 401(k) plan and ideally your employer will match that contribution (or at least partially match). The very best way to maximize your income inside your 401(k) is to contribute enough to maximize your employer’s contribution.

401(k) Basics: 401(k) plans are available to employees of those companies that offer them. The best companies have very generous plans and consider them to be a major employee benefit that greatly helps with job retention.

How It Works: The plan sponsor (employer) offers the 401(k) to their employees to help them save for retirement. The employee contributes a portion of their salary and decides how to invest those contributions from a choice offered by the service provider. The employer contributes an amount as well to boost the savings. Your contributions will be treated in a tax advantaged way by the IRS.

Since you are diverting salary right off the top of your pay check you are lowering the amount of taxable income. This might drop you into a lower tax bracket and decrease your overall tax payable. When you make a withdrawal after retirement you will be taxed as though it was normal income. If you have a Roth 401(k) then your contributions are made with after tax dollars and your retirement income will be tax-free.

Contribution Limits: The maximum that an employee is allowed to contribute in 2020 is $19,500 (or $26,000 if the worker is over 50 years of age). The maximum joint – employee and employer - contribution is $57,000 (or $63,500 for those aged 50 plus). Surveys have shown that on average the employer will contribute 50 cents for each dollar that the employee contributes up to a limit. Typically, this limit is 3% of salary. Therefore, if you contribute 6% of your salary, your employer will kick in the maximum 3% and in effect this will mean that you are saving 9% of your salary each and every year.

Another way to look at this situation is that so long as you contribute to the company 401(k) plan your returns will be at least 50% due to your employer matching contribution. Since a 50% return on investment is spectacular no matter how you look at it, it only makes sense to contribute enough yourself to maximize your employer contribution.

Withdrawals: 401(k)s are intended to be used in your retirement. As such there are severe penalties if you try to withdraw from them before retirement. If you try to make a withdrawal before you reach the age of 59 ½ years you will have to pay a 10% tax in addition to the income tax and possibly also state taxes. Please do not do this unless you literally have no other option.

There are number of events that allow for a withdrawal without penalty.

• Employee reaches age 59 ½ years.
• Employee retires.
• Employee dies or becomes disabled.
• Employee experiences a specific hardship as defined under the plan.

You can also make a withdrawal if:

• Employee leaves job.
• Plan is terminated.

Keep in mind that penalties can still be applied if you are not old enough. If you are encouraged to make a withdrawal when the plan is terminated or you leave your job the best thing you can do is to rollover your funds into a new 401(k) plan with your new employer or do a direct transfer to an individual retirement account (IRA).

This year, because of the global COVID-19 pandemic, the CARES act allows you to withdraw up to $100,000 from your 401(k) plan without having to pay the 10% penalty. You will still have to treat the withdrawal as income and pay tax on that sum, but you will have 3 years to pay that income tax to the IRS.

Investment Options: Your plan service provider will supply a number of options that you can choose to invest in. Typically, these will be mutual funds but hopefully you will also be able to choose some index funds or ETFs. I say index funds or ETFs because they will be less expensive than an actively managed mutual fund.

The service provider charges for their services (of course) and these fees come out of your investment earnings. The fees are used to pay for the record keeping and administration of the plan, but also to pay for any research the fund does, fund manager salaries and the costs of buying and selling shares. The more you keep those fees to a minimum the more will remain in your 401(k). Studies show that if you choose low-cost index funds instead of actively managed mutual funds you will outperform 90% of those funds (in the same asset class).

Strategies to Generate Income and Maximize your Returns: As mentioned above the single best thing you can do is to contribute enough so that you maximize your employer’s matching contribution no matter what the amount. Even if your employer is only giving 10% of your contribution this is like earning a 10% return on your investments – which in these days is very good. Often your employer’s contribution will be 50% - so consider that to be a 50% return on your investments. Fabulous.

The other winning strategy is to start early and never make a withdrawal before retirement. When you start early you are harnessing the power of time. The longer you have to compound your interest and grow your accounts tax-free the larger they will be when you need them upon retirement.

Let’s look at an example of the power of time. If you start early and contribute $2000 per year when you are 20 years old and maintain that until you reach age 60 you will have contributed $80,000 over 40 years. Invested at 8% your nest egg will have grown to over $560,000.

Now let’s suppose you start late but do your best to catch up by contributing $8,000 per year from the time you are 50 until you plan to retire at 60. You have still contributed the same $80,000 as above and invested at the same 8% your nest egg will have only grown to less than $118,000 upon retirement.

Even if you can only contribute a small amount when you are young your best chance of a comfortable retirement is to start saving as soon as you take your first job. It is recommended that you set aside 10-15% of your salary and “pay yourself first” by contributing to your 401(k) or IRA before paying your bills and planning your vacations.

Diversification: A third strategy is to diversify your investments. Your plan service provider will have a number of funds to choose from. US large-cap, International Mid-cap, Emerging markets, REITs, Commodity funds, Value, Dividend, Growth, Bonds and more. Depending on your risk profile (how much time you have before retirement and how comfortable you are with risk) you will choose different funds in different asset classes. By diversifying you are limiting risk so it is a good idea to spread your investments around. Some US, some international, some bonds for stability, some REITs to capture different market cycles and some small cap value to capture some high flyers. Talk to a professional to help determine your risk profile or there are many online calculators as well. In general, the younger you are the more risk you can tolerate – because if you get wiped out you have more years to recover.

Conclusion: To really generate income in your 401(k) you must do three things: Start early so that you can capture the power of compound interest over the longest period of time. Contribute enough so that you can maximize your employer’s contribution to your retirement. This is like getting free money and will turbo charge your investment returns. Lastly be sure to diversify your investment so that you can safely weather the storms that always come our way.