401k Basics

Published by Angela Lim on

Personal Finance Blog Post About What 401k Is_Me and My PF
Personal Finance Blog Post About What 401k Is_Me and My PF

What is It? - The Basic Definition

It’s an employer sponsored retirement plan that allows eligible employees to contribute on a pre/post tax basis. If you work for the government the TSP and 403(b) function like 401ks. Contributions are made through automatic deductions from your paychecks.

When Can You Start Contributing to a 401k?

Because it is an employer sponsored plan, you need to first check if your employer offers a 401k plan to its employees – unfortunately not all companies offer one. Next, you need to find out if you qualify for your company’s 401k plan. Sometimes companies require you to work for a certain amount of time before you qualify or only offer it to certain employees (such as full-time and/or salaried employees). If your employer offers a 401k plan and you’re qualified to contribute to one, talk to your HR team about opting in to the plan and start contributing! You will most likely have to create a login ID and password for your account.

*If you have your own company you can also start your own 401k plan, look into a Solo 401k!*

As of 2019, the maximum contribution an individual can make to his/her 401K is $19,000/year. If you’re 50 yrs old or older, you can contribute up to $25,000/year. The contribution timeline is a regular calendar year so for 2019 you have from January 1st till December 31st to contribute to your 2019 401K. The 2020 maximum contribution increased to $19,500 ($26,000 for those who are 50+yrs old). Note: the below examples are using 2018 numbers because I’m too lazy to update it.

*Edit made on 11/24/19

What 401K Provider Can I Choose From?

Again, because it is an employer sponsored plan you only have one choice, whichever 401k provider your employer chose. Unfortunately, not all 401k providers are equal. Some providers charge much higher fees, provide limited options, and/or provide not-so-great options. If your 401k provider is not-so-great you may want to look into first maxing out your IRA before your 401k.

Why are they so great?

Possibility of Free Money

Some employers offer something called a 401k match, which is essentially free money for contributing to your 401k. If your employer offers a 401k match, make sure to take full advantage of it by at least contributing enough to get the full match.

Example:

Julie makes $50,000/year and her company gives her $.50 for every $1 she contributes to her 401K up to 5% of her income (or 5% * $50,000 = $2,500). If Julie wants to receive the maximum employer match she needs to contribute 5% of her income. By year’s end, Julie will have a total of $3,750 ($2,500 from her and $1,250 from her employer)

Summary:

  • Salary: $50,000
  • Employer matches 50% of 401K contributions up to 5% of total income
  • To receive the maximum employer match of $1,250 (50%*5% * $50,000), Julie needs to contribute 5% of her income

*Edited 7/26/18 Accidentally did 10% of income when the employer match is capped at 5%

Special Tax Benefits

Unlike regular investment accounts, 401k plans have special tax benefits which are dependent on which plan you go with.

1. All contributions made to your 401k grow untaxed as long as they remain in your 401k account. For example, some investments payout a dividend or a regularly paid out sum of money. With regular investment accounts, you would have to pay taxes on these dividends but not with 401ks.

2. Traditional 401k contributions are made with pre-tax dollars, meaning contributions are made before taxes are deducted. These contributions lower your taxable income dollar for dollar.

Example:

    In 2020, Julie will make $50,000 and contribute $5,000 of her income to her Traditional 401k. When Julie does her taxes next year she will only have to report that she made $45,000 ($50,000 – $5,000 contribution). How does this affect her taxes? Julie ends up saving an extra $1,100 in taxes (22% * $5,000 = $1,100 see below for explanation)

    Summary:

    • Salary: $50,000
    • Contribution: $5,000
    • Taxable income during tax time: $45,000
    • Additional savings from lower taxable income: $1,100
    • Tax savings explanation: At an income level of $50,000 Julie is at the 22% tax bracket for 2020. If she did not contribute $5,000 to her traditional 401k, she would have to pay a 22% tax on it which would be $1,100 ($5,000 * 22% = $1,100)
    • *Depending on your state you can save more money from state taxes as well. You can save more money by contributing more and/or being in a higher tax bracket.

    3. Roth 401k contributions are made with after tax dollars, meaning contributions are made after taxes have been deducted. These contributions don’t have immediate tax benefits, but distributions taken at retirement age (59.5 years old) are tax free.

    Example:

      Julie makes $50,000/year and contributed $5,000 to her Roth 401k. When she does her taxes next year, she pays taxes on the full $50,000 she made. However, in 40 years if that $5,000 contribution grew to $50,000 (assuming 6% annual growth per year) and she starts withdrawing money from her Roth 401k, she pays no taxes on that $45,000 gain ($50,000 – $5,000 = $45,000).

      Summary:

      • Salary: $50,000
      • Contribution: $5,000
      • Taxable income during tax time: $50,000
      • Future Scenario: Contribution grows to $50,000 after 40 years (6% annual growth per year).
        • Gains: $45,000
        • Taxes paid during retirement on the gains: $0

      *Keep in mind that not all companies with 401ks offer a Roth option.

      Special Protections

      Generally, 401k plans have special protections (The Employee Retirement Income Security Act AKA ERISA) that prevent creditors from going after money in your 401k, even in the event of bankruptcy. These special protections don’t apply to assets like your checking/saving accounts, home, regular investment accounts, etc. Also, whether you have a few thousands of dollars or a million dollars in your 401k plan, you are able to take advantage of these special protections. Basically, if you go bankrupt, debt collectors can’t touch your 401k. There are exceptions in the case of family support or divorce. You can read more about ERISA here.

      Traditional vs. roth

      It depends. The general rule of thumb is that if you make less money opt for the Roth 401k (if possible) and if you make more money opt for the Traditional 401k. See the below simplified chart to see which tax bracket you fall in according to your income. *Single Folks = anyone who is not married. If you’re dating someone you’re still considered single by the IRS

      When to go roth

      If you are in the 10% or 15% tax bracket, you should opt for the Roth 401k (if possible) since you’re in a relatively low tax bracket and will most likely make more money in the future and be pushed into higher tax brackets. Remember, with Roth, you pay taxes now but have the benefit of not having to pay taxes when you take money out of your Roth 401k at retirement. Basically, if you think you’ll make more money in the future, choose Roth IRA.

      When to go Traditional

      The more money you make, the more it makes sense to contribute to a Traditional 401k account. Why? Because the more money you make the more taxes you need to pay. However, contributing to a Traditional 401k account can help lower your tax bills and the savings are more significant the higher up in the tax bracket you’re in. So, if you’re in the 32%+ tax bracket, I would suggest a Traditional IRA account. 

      Debatable

      For the 22% & 24% tax brackets I put debatable because people argue for both Roth and Traditional but I think that past the 15% bracket you should opt for Traditional, especially if you aren’t at the point of maxing out your 401k. Why? Because you’ll be able to contribute more if you go Traditional vs Roth since contributing to a Traditional 401k means you pay less taxes and having more $ invested earlier means you take better advantage of compound interest!

      Example

      Julie got a raise and now is making $80,000/year but needs $61,948/year for her expenses. After taxes, how much can she put in her 401k account?
      Turns out, if she goes with a Traditional 401K she can put away $1,760 more than if she opted for the Roth 401k. This is because Julie ends up having to pay $1,760 more in taxes if she goes with the Roth 401k. *Remember Traditional 401K contributions decrease your taxable income!*

      *I only included federal income taxes, input 1 federal allowance, and used Single for filing status

      Summary:

      • Salary: $80,000
      • Need a take home amount of: $61,948
      • Traditional 401K: can put away 10% of gross salary or $8,000
      • Roth 401k: can put away 7.8% of gross salary or $6,240

      You can use this ADP Salary Calculator to see the difference in your salary for Traditional vs Roth Contribution. Link here.

      How much should i contribute?

      This is dependent on a billion factors, but generally I’d say try to contribute as much as comfortably possible. Remember, there are pretty exceptional tax benefits to contributing to your 401k that you don’t get from contributing to other types of investment accounts. Also, keep in mind that you can’t retroactively contribute to your 401k. If you’ve skipped out on contributing for the first 5 years you can’t later decide to go back and contribute for those years. If your company offers a 401k match, you should aim to contribute enough to max out on that match (remember, it’s free money!). Even if you don’t have a match, start off at 5% and if you don’t really feel the difference, increase the percentage until you feel a little stretched. Aim to eventually max out – doing so will greatly help build your retirement cushion!

      *If you have crazy high interest debt (like credit card debt) or unmanageable/almost unmanageable debt, focus on those debts before thinking about contributing to a 401k.

      The Catch: Potential Penalties

      So, what’s the catch that comes with the 401k? Withdrawing from your 401k early, or before 59 ½ years old, comes with a 10% penalty + paying for ordinary income tax if withdrawing from a traditional 401k account. There are some exceptions that allow you to avoid the 10% penalty which you can read more about here.

      Despite the potential penalties, a 401k is definitely worth contributing to. I mean, there are so many tax benefits that regular, taxable investment accounts don’t provide which means significantly more $ for retirement. Also, there are a few ways to orchestrate penalty-free early withdrawals without having to meet any special exceptions.

      What should i invest in?

      Low-cost Index funds! Not all 401ks are created equally, some are much better than others, but what you should do is look for diversified, low cost index funds. Index funds are exactly what they sound like, funds that just aim to track to an index – think S&P 500. They allow you to be invested in hundreds or even thousands of companies so that not all your eggs are in one basket. Also, because index funds aren’t looking to “beat the market” they require minimal upkeep and therefore have a much lower expense ratio (aka the annual fee that funds charge). Index funds typically have an expense ratio of .25% (although there are some as low as .04%) or lower while actively managed funds (funds that are trying to actively “beat the market”) can charge you more than 1% of your assets. While 1% doesn’t seem like a crazy high amount, over a few decades this can amount to hundreds of thousands of dollars. (Link to article showing cost differences)

      Allocation

      How much you allocate to stocks vs bonds depend on a number of factors such as your risk tolerance and age. Generally, people recommend a 90/10 stocks/bond ratio for younger folks (people in their 20s and 30s) and as you age slowly lean more towards bonds.

      Target Date Funds - For the lazy

      If you just want a set-it-and-forget-it fund look into low-cost Target date funds. These funds typically ask you how old you are or when you’d like to retire by and automatically adjusts your allocations as you get older. Typically, the closer your target retirement date is, the less aggressive your allocations are. Like many products, not all Target date funds are equal so make sure to be aware of the expense ratio fees before choosing one (a reasonable fee is .25% or less).

      DIY Option

      Vanguard Example:

      • Domestic Stock Exposure: VTI or VSTAX (or something similar to these accounts –researching can be as simple as Googling the funds your company offers)
      • International Stock Exposure: VGTSX or VTIAX
      • Bond Exposure: BND

      *You can Google the equivalent funds from above for whichever provider you have.

      How do i time the market?

      You don’t. No one knows with certainty what will happen in the market. “Experts” spend all day trying to find clever ways to “beat the market” but only about 1 out of 20 do (Link to article). It’s better not to make investment decisions off of feelings or you can very much end up buying high and selling low. So rather than spending time and effort trying to time/beat the market work to invest early and ride it out for the long-term (I’m talking a few decades here people). DON’T make hasty decisions such as cashing out your 401k during a sharp downturn – keep calm and hold on.

      Unsatisfied with my answer? I recommend reading the theoretical story of Bob – the world’s worst market timer who only accidentally only invests during market peaks, but continues to invest during market downturns. TL;DR:  After investing $184K over the course of 43 years and 4 huge market crashes Bob ends up with $1.1 MM. If he didn’t try to time the market and invested his money evenly instead of market peaks he would’ve ended up with ~$2.3 MM.(Link to full article)

      TL;DR

      1. 401k is an investment retirement account from your employer that has great tax benefits

      2. A 401k is a unique retirement vehicle that offers tax benefits, special protections, and potentially free money.

      3. Starting earlier will give you a huge boost with your savings, so contribute whatever you can to your 401k as soon as you can

      4. Max out your 401k 

      5. Get a Roth IRA if you think you’ll make more money in the future. Get a Traditional IRA if you are already making a lot of money.

      6. Withdrawing from your 401k early or before age 59 will come with monetary penalties, so avoid doing that.

      7. For people in their 20-30s, it’s recommended to allocate 90% to stocks and 10% to bonds.

      8. Invest in low-cost index funds. For the lazy, you can use target date funds. 


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