How the Super Rich Use 401(k)s

A 401(k) plan can be an important part of a retirement savings strategy. Contributions can reduce taxable income for the year and grow tax-deferred. Meanwhile, employees can collect free money in the form of employer matching contributions. As of June 2021, 401(k) plans held an estimated $7.3 trillion in assets, more than double the amount they held a decade previously. Higher-income earners may have an advantage when it comes to maxing out 401(k) plan contributions. The secrets of the super-rich can be a guide for everyday 401(k) savers who want to make the most of their plans.

Key Takeaways

  • A 401(k) plan is a tax-advantaged retirement savings plan that’s offered by employers to employees and funded through elective salary deferrals.
  • An estimated 60 million Americans have at least one 401(k) plan that they’re actively using to save for retirement.
  • Super-rich savers may have an edge when maxing out 401(k) plans if they’re able to fully fund contributions each year.
  • Highly-compensated employees (HCEs) have specific limitations on how much they can contribute to their 401(k) plan.

Rich Savers Have a 401(k) Advantage

Earning more money can give someone a definite edge when saving in a 401(k) for one simple reason: they may be able to afford to make larger contributions each year. For 2022, the maximum 401(k) contribution is $20,500. An additional catch-up contribution of $6,500 is allowed for savers aged 50 and older.

Assume that you’re able to fully fund your 401(k) each year, up to the $20,500 limit. You contribute that amount annually from age 30 to age 65, earning a 7% annual rate of return. If you retire at 65, you’d have just over $3.5 million saved for retirement, not including any additional catch-up contributions you make between age 50 and 65.

At a lower income level, you can still see substantial gains from consistent contributions. Let’s say you make $50,000 a year and save 10% annually in your 401(k). Over that same time period, earning that same rate of return, you’d accumulate a little over $928,000 in retirement savings. That example illustrates the long-term benefits of being able to contribute larger amounts to your workplace plan.

For further perspective, the average 401(k) plan balance was $141,542 in 2021, according to the latest Vanguard How America Saves report. The median balance was $35,345. While both figures represent year-over-year increases, they highlight the fact that the typical 401(k) saver is likely not among the super-rich.

Important

Over-contributing to a 401(k) plan can result in a 10% tax penalty.

401(k) Rules for Highly Compensated Employees (HCEs)

The IRS sets annual contribution limits for 401(k) plans but there are additional rules for highly compensated employees (HCEs). A highly compensated employee is defined as an individual who:

  • Owned more than 5% of the interest in the business at any time during the year or the preceding year, regardless of how much compensation that person earned or received, or
  • For the preceding year, received compensation from the business of more than $125,000 (if the preceding year is 2019, $130,000 if the preceding year is 2020 or 2021 and $135,000 if the preceding is 2022), and, if the employer so chooses, was in the top 20% of employees when ranked by compensation.

The distinction between highly compensated employees and other employees is important because 401(k) plans are subject to nondiscrimination tests. These tests are designed by the IRS to make sure that an employer isn’t favoring higher earners over other workers.

In order for a plan to pass nondiscrimination tests, the average contributions by HCEs cannot exceed 2% of the contributions made by non-highly compensated employees. For example, if all the non-highly compensated employees of a company collectively contribute 6% of their salaries on average, then a highly compensated employee can’t contribute more than 8% of their earnings.

The IRS also puts a separate cap on total contributions made by highly compensated employees. Under this rule, the total contributions for all HCEs can’t exceed the combined contributions of all non-highly compensated employees by 2%. These rules essentially dictate just how much a higher earner can contribute to their plan each year.

Note

If a 401(k) plan fails nondiscrimination tests, they must remedy it by making qualified nonelective contributions on behalf of non-highly compensated employees.

How to Use Your 401(k) Like the Super Rich

If you’re interested in building wealth and joining the ranks of the rich for retirement, it’s important to have a plan. There are simple—but effective—strategies you can apply to make the most of your 401(k)’s potential during your working years and beyond.

  • Review your contribution rate. The simplest way to give your 401(k) a boost is to raise your annual contribution rate. The closer you can get to maxing out the annual contribution limit, the more room your money has to grow. If you’re unable to make large increases in your contribution rate at this time, consider doing so in smaller increments of 1% to 2% each year.
  • Play catch-up. Ideally, by the time you turn 50 you’re in your peak earning years and can afford to make the full contribution to your 401(k) annually. You can step up your savings efforts by also making catch-up contributions up to the annual limit.
  • Review investment performance. Investing part of your salary into your 401(k) is just one component of a wealth-building strategy. You also need to create a portfolio of diversified investments that can offer the right combination of risk and reward to meet your goals. If you haven’t checked your investment performance lately, you may want to see which holdings are doing well—and which ones you may want to unload.
  • Keep fees in check. There are plenty of fees associated with 401(k) plans; some you can control, others you can’t. One thing you do have a say in is what you pay to own mutual funds and exchange-traded funds (ETFs). Opting for funds with lower expense ratios can reduce fees and allow you to keep more of your returns.

Tip

If you want to step up your efforts to build wealth even more, consider supplementing your 401(k) savings with a traditional or Roth IRA.

Can You Get Rich With a 401(k)?

A 401(k) can be an important building block in your financial plan if you hope to become rich. The more you can afford to contribute to your plan each year and the earlier you begin saving, the larger your balance may be once you’re ready to retire.

Can I Make a Million Dollars With My 401(k)?

It’s possible to grow a 401(k) balance to $1 million or more, though it does require some careful planning. To make a million dollars with a 401(k), you’ll generally need to save early and often, max out the plan’s contribution limit as much as possible each year, minimize the fees you pay, and make smart investment choices.

Do Millionaires Use 401(k)s?

Plenty of millionaires and super rich people use 401(k) plans to build wealth. But they don’t necessarily put all their eggs in one basket. They may also supplement their 401(k) savings with IRAs, taxable brokerage accounts, annuities, real estate, and other investments.

Bottom Line

If you have a 401(k) plan at work, taking advantage of it can help you get closer to your retirement goals, including becoming super rich. By saving early and regularly, you can capitalize on the power of compounding interest over time. Also, remember that it’s consistency that counts most. Staying the course with your 401(k)—even when the market is volatile—can pay off in the long run.

Source: https://www.investopedia.com/super-rich-401-k-s-5323955?utm_campaign=quote-yahoo&utm_source=yahoo&utm_medium=referral&yptr=yahoo