(MoneyWatch) A new report that considers how financially prepared Generation-X'ers are for retirement concludes that eligibility to participate in an employer's 401(k) plan is the single most important factor in closing their retirement savings gap. Of course, just being eligible to participate in a plan isn't enough -- you actually have to participate, as well as take several critical steps.For younger workers today, 401(k)-style savings plans are the primary, and typically only, plan to save for retirement. And how they handle this "do-it-yourself" saving system will spell the difference between being financially secure during their retirement years and living on the edge. Here's a 401(k) action plan for folks in their 20's and 30's.
Join your company's 401(k) plan as soon as you become eligible. Most companies will require you to be employed for six months to a year to join the 401(k) plan, but a growing number of businesses allow workers to participate immediately. So find out when you are eligible to join, and enroll as soon as you can. Also find out how much you need to contribute in order to receive the maximum matching contributions from your employer (assuming one is offered). Most employers will require you to contribute at least six percent of your pre-tax pay to get a three percent employer match.
If you're not eligible to participate in a 401(k) plan, you do have options. Self-employed people can establish and contribute to a self-employed 401(k) plan, where you make contributions to your own account as both the employer and employee, for a total pre-tax contribution of up to $50,000 per year (up to $55,500 if over age 50). If you have $5,000 or more in earnings, you can contribute up to $5,000 (up to $6,000 if over age 50) to an Individual Retirement Account, or IRA.
The point is that having access to a 401(k) is not necessarily a requirement to being able to save for retirement in a tax-advantaged retirement account.
Contribute 10 percent. Most employer-sponsored 401(k) plans will provide a matching contribution on up to 6 percent of employee contributions. But this is not some implied message for what you should be contributing. Several studies have concluded that for the average worker, if you are working and saving for retirement over 30 years and all you will have to draw on is your 401(k) and Social Security, you will need to contribute a total of 13 to 15 percent of your pay each and every year into your 401(k) plan account to have a reasonable chance of having enough money to fund your retirement. So if your employer contributes three percent and you contribute 10 percent, the total contribution would be 13 percent.
Juggling debt payments and retirement savings can also be a struggle. If you have student loans, don't sacrifice 401(k) plan savings to make extra principal payments on these loans. Instead, consolidate your student loans into a single loan with a lower payment, which frees up cash-flow to contribute to your 401(k).
But if you have credit card debt, the advice is different. Contribute an amount to the 401(k) plan to get the maximum employer's matching contributions (typically 6 percent) and then use any extra income to pay down your credit card balances as quickly as possible. That is because while the return on the "matched-contributions" is hard to beat, the return on the unmatched contributions is not likely to exceed the 18 to 29 percent interest rate you could be charged on the credit card debt. If you lack the discipline to go back and increase your 401(k) contributions after you pay down your credit card debt, then just start out at 10 percent.
Make Roth 401(k) contributions. Many plans today also allow a feature called Roth 401(k) contributions. These are deducted from your after-tax pay, but all of the growth on these contributions is tax-free at retirement when the money is withdrawn. This can be a significant benefit to younger workers, who will be investing for a long time and thus can expect to see a longer period of growth for their retirement savings. If your plan offers this feature, then make some or all of your contributions in the form of a Roth 401(k) contribution.
Escalate contributions. If you absolutely cannot afford to save 10 percent of your pay right now, then begin with at least the minimum required to receive the maximum employer matching contributions, and automatically increase your contributions each year to coincide with your annual pay hike. Many 401(k) plans include an automated feature called a "contribution escalator," which you can set up to automatically increase your contributions by a defined amount on a pre-set date in the future.
Invest for maximum growth. According to major 401(k) plan service providers, younger employees invest more conservatively than their parents do, allocating some 35 percent of their retirement funds to lower-risk bond and stable value funds. Studies show that some 19 percent of workers in their twenties have no stock investments in their 401(k) accounts. Clearly, the reason for this is the recent experience with stock funds during the recent financial crisis. But the younger you are, the more time you have to save and invest. As a result, most of your retirement account and future contributions should be allocated to stock funds, which over time should outperform lower-yielding bond funds.