Maximizing Your $850 401(k): Strategies for Retirement Income

Retirement can be a daunting prospect, especially when your 401(k) balance is modest. With just $850 in your 401(k) account, it might seem like you're starting from scratch. However, with the right strategies, you can turn this small nest egg into a reliable source of retirement income. Here’s how you can maximize your $850 401(k) and ensure long-term financial stability.

Start Saving Early and Contribute Regularly

The power of compound interest cannot be overstated. Even small, regular contributions can grow significantly over time. For example, a 25-year-old investing $200 per month ($2,400/year) accumulates more assets by age 65 than if he or she had started to invest $300 per month ($3,600/year) at age 35, despite investing less each period. This assumes an average annual nominal return of 7.8%. The key takeaway is to start saving as early as possible and contribute regularly to let compound interest work its magic.

Contribute to Your 401(k) Account

If your employer offers a traditional 401(k) plan, take full advantage of it. Contributing pre-tax money can significantly reduce your taxable income. For instance, if you're in the 12% tax bracket and plan to contribute $100 per pay period, your take-home pay will drop by only $88 (plus the amount of applicable state and local income tax and Social Security and Medicare tax). This means you can invest more of your income without feeling it as much in your monthly budget.

Meet Your Employer's Match

If your employer offers to match your 401(k) plan contributions, make sure you contribute at least enough to take full advantage of the match. For example, an employer may offer to match 50% of employee contributions up to 5% of your salary. That means if you earn $50,000 a year and contribute $2,500 to your retirement plan, your employer would kick in another $1,250. It's essentially free money. Don't leave it on the table.

Open an IRA

Consider establishing an individual retirement account (IRA) to help build your nest egg. You have two options: a traditional IRA or a Roth IRA. A traditional IRA may be right for you depending on your income and whether you or your spouse are eligible to participate in a workplace retirement plan. Contributions to a traditional IRA may be tax deductible, and the potential investment earnings have the opportunity to grow tax deferred until you make withdrawals during retirement. If you meet the phased-out modified adjusted gross income limits, which are based on your federal tax filing status, a Roth IRA may be a good choice for you. A Roth IRA is funded with after-tax contributions, so once you have turned age 59½, qualified distributions, including any potential earnings, are federal income tax-free (and may be state income tax-free) if certain holding period requirements are satisfied.

Take Advantage of Catch-Up Contributions

If you're age 50 or older, you're eligible to go beyond the normal limits with catch-up contributions to IRAs and 401(k)s. So if over the years you haven't been able to save as much as you would've liked, catch-up contributions can help boost your retirement savings.

Automate Your Savings

If you have young kids or you’re still building your career, retirement may not be top of mind at this point in your life. But someday, if you’re lucky and save on a regular basis, it will be. To have the best retirement, it’s wise to create a plan early in life — or right now if you haven’t yet done so. By diverting a portion of your paycheck into a tax-advantaged retirement savings plan, for example, your wealth can grow exponentially to help you achieve financial security for those so-called golden years.

Leverage Other Investment Options

Retirees with limited 401(k) savings can leverage other investment options to supplement their retirement income. One effective strategy is to use income annuities. An income annuity is a contract between the retiree and an insurance company where the retiree pays a sum of money in exchange for regular income payments. This can provide a steady, predictable source of income in retirement, regardless of market fluctuations. For example, "Annuities can help you set up a guaranteed income stream for a certain period of time or for the rest of your life. You can also choose to have this income paid through your own lifespan or through the lifespan of you and another person (e.g., your spouse)." This makes annuities a reliable option for retirees looking to ensure a stable income stream.

Another option is a diversified bond portfolio. Bonds have become more competitive as a source of income for retirees due to rising interest rates. For instance, "the 5-year U.S. Treasury note yielded 1.37% at the beginning of 2022; by the end of May 2023, the yield was 3.74%." This increase in bond yields can provide retirees with a more substantial income stream compared to previous years. Bonds are available in various forms, including U.S. Treasury securities, municipal bonds, and corporate bonds, offering flexibility in investment choices.

Dividend-paying stocks are another viable option. These stocks offer retirees income generation along with potential for growth. "Dividend stocks tend to be less volatile than non-dividend-paying stocks," and the consistent stream of income from dividends can cushion the impact of a bear market. For example, "Dividend growth is one of the few ways to generate a stream of income that will increase over time." This makes dividend-paying stocks a valuable addition to a retirement portfolio, providing both income and potential for capital appreciation.

Additionally, retirees can consider high-yield savings accounts, certificates of deposit (CDs), and Treasury inflation-protected securities (TIPS). High-yield savings accounts offer a safe place for cash while earning a higher interest rate than traditional savings accounts. CDs provide a stated return in exchange for leaving money locked up for a set period, offering higher interest rates than regular savings accounts. TIPS are designed to protect against inflation by adjusting their principal value along with the consumer price index, making them an excellent choice for retirees looking to preserve their purchasing power over time.

Conclusion

Retirement planning with a small 401(k) balance requires a strategic approach. By starting early, contributing regularly, and leveraging other investment options, you can maximize your retirement income and ensure long-term financial stability. Whether you choose income annuities, a diversified bond portfolio, dividend-paying stocks, or other investment options, the key is to diversify your portfolio and stay disciplined in your savings and investment strategies.

Ask Aime: How can a modest 401(k) balance be turned into a reliable retirement income source?