The 401(k) retirement account is one of the most popular ways to save for retirement. Because living off Social Security just isn’t a reality for everyone, it is crucial to be able to maximize the benefits from your retirement accounts. In this article, we’ll go through the types of 401(k)s, benefits, limitations, and strategies.
Introduction to the 401(k)
Originally enacted in 1978, the traditional 401(k) remains one of the most popular retirement plans to date, due to its flexibility in asset allocation and employer benefits. The 401(k), which can be opened after 18 years old, is an employer-match retirement plan in which the employee contributes to their account from their paycheck and the employer will match the amount contributed (depending on employer, the match could be dollar for dollar or less up to a capped percentage) in the same account.
In the first scenario, your contributions are fully matched, or dollar for dollar. For example, Jim works at Company A and wants to open a traditional 401(k). Jim deposits $1000 monthly into the 401(k). Jim’s employer, Company A, has a 100% employer match policy. This means they would match Jim’s $1000 (which is directly taken from his paycheck before taxes) with another $1000. That totals a $2000 deposit into Jim’s account.
Michael’s company, Company B, might not do a full employer matching contribution. Perhaps they choose to only match half of the amount from the employee’s contributions. In this scenario, Michael contributes $1000. But, his employer, Company B, chooses to only match half of that, which is $500. The total deposit to Michael’s 401(k) amounts to $1500.
Capped Matching and Investment Options
Most companies offering the employer match will do so up to a certain percentage. This capped percentage is based on an individual employee’s income. For example, if you are making $100K a year and your employer offers a 3% dollar for dollar match (shown above in Jim’s situation), it would mean that you can add up to $3000 (3% of your $100,000 annual income before taxes), and your employer will match that $3000 with another $3000, totaling $6000 into your account. If you want to put any more than $3000, that’s fine. But, you won’t be receiving any more money in the form of an employer match because that would exceed 3%. This percent varies at every company, and some companies may not offer any matching contributions at all.
Employers can use higher 401(k) contribution match percentages to attract new employees and retain older workers. Subsequently, employees must choose where to allocate their money in a consortium of different investments. These investments include but are not limited to company stocks, bonds, and mutual funds. Depending on which options you choose, assets within your 401(k) can grow at different rates.
Investment options within the 401(k) are also company-specific and can vary by employer. The 401(k) caps employee contribution at $19,500 per year (as of 2020). But it’s likely to adjust for future inflation (increase in prices). The $19,500 contribution is also money taken before taxes. This means it will not be taxed initially when you contribute to the account. However, it will be taxed when you withdraw the money from the account, based on whatever the tax rate is at the time of withdrawal.
Basics: Traditional 401(k) vs. Roth 401(k)
There are two types of 401(k)s, the Traditional and the Roth. The biggest difference between the two is that the Traditional 401(k) is tax-deferred. This means that you pay taxes on the money after you withdraw from the account, as opposed to before you put the money in the account in the first place. This means that you are paying taxes on both your principal and the compounded interest gained during the time you made contributions to the time you withdraw. The Traditional 401(k) is more common.
The key difference with a Roth 401(k) is that you aren’t taxed upon withdrawal of funds. This is because money deposited into a Roth 401(k) is post-tax money. This means it had originally already been taxed before being deposited into the account. In the long run, this means that when you withdraw your money, it will not be taxed because it has already been taxed initially. This is extremely beneficial because it means you are losing money to income taxes only on your principal, and not everything you earned in the decades of compounded interest that took place while getting to retirement. In addition to this, taxes rise with inflation, so paying lower taxes in the present will allow you to avoid inflated taxes in the future, assuming your income remains stable.
Traditional 401(k) or Roth 401(k)
You may be thinking that the Traditional 401(k) sounds impractical if the Roth 401(k) can help you avoid higher taxes. However, you have to make your decision based on whether or not you think you will be in a higher tax bracket in retirement than you are right now. If you will likely be in a higher income tax bracket in retirement, you would want to pay the taxes now, rather than later, to avoid higher income tax later. If your income is expected to drop in the future, you would want to opt for the Traditional 401(k), as the taxes upon withdrawal will be less than in the present, due to being in a lower tax bracket.
In general, more companies will offer a Traditional 401(k) than the Roth 401(k), and individuals will use a combination of Traditional 401(k) and a Roth IRA to set up for retirement, which we will discuss at length later on.
Limitations and Restrictions
Unfortunately, there is a caveat to the 401(k) plans. Because the plans are geared toward retirement, the money cannot usually be withdrawn before the age of 59 and a half. If the money is withdrawn before, the employee is subject to a 10 percent penalty on all contributions as well as immediate taxation.
For example, let’s say Jim from Company A had accumulated $100,000 in his 401(k). But, he decided that he wanted to withdraw the money for a down payment on a new home. He then would be subject to a 10% penalty on that $100,000, or $10,000. Federal and state taxes will take another significant portion of Jim’s remaining $90,000.
Special circumstances, however, like the COVID-19 pandemic in 2020, have allowed employees to withdraw from their 401(k)s without a penalty. Additionally, the customary taxation has been extended to a 3-year repayment period. Currently in 2020, under the Coronavirus Aid, Relief, and Economic Security Act, or CARES Act, the IRS has implemented a generous policy in aiding citizens with financial hardships. Withdrawn funds up to $100,000 will not be taxed immediately. Rather, they will be taxed over the course of three years from 2020 to 2022.
First off, it is best to invest as much as your employer matches, assuming that there is a match. A match can effectively double your savings! While most people would call it free money, some actually see it as part of your compensation package. More employer benefits means less base salary. Perhaps at another company that does not offer a match, you could be making more money. So in a way, not contributing to your 401(k) to fully utilize the employer matching contributions is similar to leaving money on the table.
Although a Traditional 401(k) is tax-deferred and technically not as preferable as a Roth IRA in that sense, the match makes the Traditional 401(k) a must. If you still can contribute to retirement accounts after making contributions to your Traditional 401(k), then start contributing to your Roth IRA. This is because putting more money into your Traditional 401(k) reaps no more matching contributions as you’ve hit the percentage limit, so the Roth IRA, with its tax-exempt withdrawal benefit, becomes more preferable. If you still have money after contributing to 401(k) up to the employer match and maxing out your Roth IRA limit of $6000, only then you go back to your Traditional 401(k). To learn more about IRAs, visit this article.
That was a lot. Here’s some numbers to see what it might look like in real life.
Let’s say you are making $100,000 a year (nice!). Your employer offers a generous 3% match on Traditional 401(k) contributions. This would be the strategy for most people:
- Contribute $3000 into your 401(k) to fully take advantage of the matching contributions. Your 401(k) is now at $6K, which is $3000 from you, and $3000 from your employer. Note that any more contributions will not be matched since you’ve hit the 3% limit. That’s why we now move on to…
- Your Roth IRA account. The Roth IRA limit of $6000 is relatively low when compared to the 401(k) limit of $19,500 in 2020 because it enjoys the tax benefit of not having to pay taxes upon withdrawal. So, max out your Roth IRA with $6000 of contributions. Since you can no longer put any more money into the Roth IRA, we now go back to the 401(k) account.
- With any remaining money you have left to contribute to your retirement account, which will vary with your own personal budget, place it in your Traditional 401(k). Based on our initial contribution of 3K back in Step 1, the max amount you can contribute at this point is $16,500 because you would then hit the 401(k) limit.
- Traditional 401(k) up to however much your employer matches, because you don’t want to leave any money on the table. Skip this step if your employer doesn’t offer a match.
- As much as you can into your Roth IRA, because tax-exemption on withdrawals is a massive benefit.
- Back to Traditional 401(k).
Retirement accounts are preferable to having plain cash in your savings account because you can use the money in your retirement accounts to invest in stocks, bonds, ETFs, and other financial instruments. That’s why we go back to the Traditional 401(k) in Step 3 after maxing out on Roth IRA contributions, even though we no longer get the matching contributions from an employer. The idea is to let that money accumulate for decades, up until you start withdrawing from those accounts to retire. With retirement accounts, those investments allow for compounded interest, which is extremely powerful and is discussed here.
If you were to leave money in your savings account instead, not only would you be losing out on the money you could have earned in returns from investing, you are also losing money due to an average annual inflation rate of 3%. Most people use 8% as an estimated average ROI in the stock market over long periods of time. That means that you can either invest with money in your retirement account to make average real annual returns of 5% (8% returns – 3% inflation) or put it in a savings account, losing 3% per year due to inflation.
The Cardinal Benefit: Tax Write-offs
Okay, so we’ve established that retirement accounts make more sense than letting money sit in a savings account. Right now, I hope you’re asking yourself this: “Why should I use retirement accounts instead of a regular brokerage account that can also invest in investments like stocks and bonds?” If you are, then you’re asking the right questions, and you’re already half of the way there. If not, that’s fine too. This is the point of reading StreetFins articles: to build up your financial literacy, which allows for better decision making.
The reason we want to invest in retirement accounts over regular brokerage accounts, when each can invest in the stock market, bonds, and other investments in the same way, is twofold. The biggest reason is that retirement accounts have massive tax-benefits. These benefits exist because the government wants to incentivize retirement investment so that you are better off. This leads to fewer people that need to request government welfare to retire. The question is: how does contributing to a 401(k) help me, individually, become better financially equipped?
For one, 401(k) contributions are tax-deductible. This means that if you make $100,000 and you put aside $20,000 per year into retirement accounts, you are only taxed by the government on that $80,000 remaining! A 401(k)’s tax-deferral status is also a huge tax benefit. This is because you are only paying taxes upon withdrawal, somewhere around 60 years of age. With a regular brokerage account, you would have to pay taxes on each year of returns that you made by investing in the form of capital gains! Long-term capital gains rates can reach as high as 20% too. So, even if you hold stocks over a long period of time, the returns will be taxed.
Tax-deferral allows for your savings to grow much faster because your money is allowed to stay in that account to continue growing, rather than be subject to annual taxes on the money you made through investments. For a Roth IRA, the benefit is that you do not need to pay taxes on the money you withdraw. However, you may only contribute to post-tax income, any money you have left after paying taxes. This is very good because it is much better to pay taxes on your just principal. It would be a smaller amount than your principal plus decades of compounded interest.
The other reason is psychological. Contributions made into retirement accounts are easily set up to be automatically done from your paycheck every month. Additionally, the 10% penalty of withdrawing from retirement accounts before 59.5 years of age is a huge mental deterrent. This makes for a much more painless way to contribute and keeps you from picking away at your account.
By now, what a 401(k) is and why we use them should start to make sense. Don’t be discouraged if you aren’t getting 100% of this immediately. This was a dense article. However, these ideas and strategies are extremely important to know. Even if you’re not currently employed, understanding retirement strategies is one of the biggest components of financial literacy. We highly suggest bookmarking this article to reread at a later time. Financial literacy is all about setting yourself up in a mindset to ask the right questions and make the right decisions in order to build wealth and reach financial independence. With knowledge of the 401(k) retirement account and its strategies, you will be able to set yourself up for a comfortable retirement.