401(k)

401(k) accounts have become the new king of saving for retirement, and allow people to really turbo charge their retirement savings. Even though most working Americans have access to a 401(k) plan, less than 10% take advantage. We miss out on a lot when we fail to contribute as much as we should to our 401(k) accounts.

401(k) Plans Generally Serve To Increase Your Total Compensation

The 401(k) retirement plan in the United States began in 1978, and got its name from the section of IRS income tax code that denoted it. It is the most popular form of employee sponsored retirement plans, with millions of employees participating.

The main thing that sets 401(k) plans apart from individual retirement savings accounts, or IRAs, is that 401(k) plans are employee sponsored. Employees are given the option to have a portion of their earnings placed in an employer’s 401(k) plan, or to take the compensation in cash. It is generally wiser for them to participate in the 401(k) though, if they are interested in saving for retirement, and even if they aren’t.

While employers aren’t required by law to match a portion of the employee’s contribution, they generally do, and this is one of the big reasons why people invest in 401(k) plans, to take advantage of the extra compensation that they receive by doing so.

401kSo for every dollar contributed to the 401(k), the employer may match it to a certain percentage, depending on the arrangement. For instance, if you put in $1000, they might match it with $250, $500, or more. If you don’t contribute, you miss out on this extra money.

While there are people who can’t afford to contribute to a 401(k) when it is offered, or others that perhaps could if they really wanted to but aren’t willing to set aside money for this, a lot of employees take advantage of this perk.

It’s not exactly free money we’re talking about here though, as employers do factor in matched funds in total compensation. However, if one foregoes this, they are certainly getting compensated to a lesser degree by not taking advantage of this, and in a very real sense, not contributing to your 401(k) plan or contributing less than the most you could involves setting for less compensation.

So we already see a very good reason to contribute to 401(k) plans even without looking at the potential tax advantages, and that’s to simply look to get paid more. This extra compensation cannot be realized until later in life though, but later in life is when we tend to need it, once we’ve reached the age of 60 and beyond, and start to think more seriously about retirement.

How Standard 401(k) Plans Save People Money on Taxes

With a standard 401(k) plan, the idea is to not pay tax on the amount you contribute, and defer taxation on it until you retire and your income goes down. This often places one in a situation where the contributed amount gets taxed at a lower rate then it would have been had it not been contributed to the tax shelter vehicle, such as a standard 401(k) or a traditional IRA.

People often speak of being in a certain tax bracket, moving to a higher tax bracket or to a lower tax bracket. Income as a whole isn’t taxed in one bracket or another, it’s that portions of income are taxed in certain brackets. So there’s an amount that doesn’t get taxed at all, another bracket that gets taxed a certain amount, a bracket above that that gets taxed a greater amount, and so on.

If one defers the taxation on a portion of their income, we need to look at what tax would have been paid on it, and this sometimes will involve a portion of it being taxed in one bracket and a portion taxed in a higher bracket.

So we can see cases where one’s income may have gone down somewhat but the tax paid is still taxed at the same rate. However, as long as one does not get taxed at a higher rate later, there will be benefits accrued by deferring the tax, provided one’s investments generate a positive return over time, which always should be the case unless one has made some very bad investments.

So there are two main benefits to tax deferral, the tax savings itself, and the return on investment of the deferred tax. To use a simple example, if one has deferred $100,000 in a 401(k), and would have paid $25,000 in income tax if not deferred, this $25,000 sits in the investment account, and earns or at least should earn a tidy sum over the years.

So even if you end up owing the $25,000 in retirement, you’ve made money on this. If you owe less, and only end up paying $15,000, you’ve saved an additional $10,000. You also benefit from the principal amount owed being devalued by inflation, and the IRS is actually losing money every year by letting you defer the tax, because a given amount becomes worth less each year in real dollars.

With a 401(k), if you get the additional benefit of your employer matching your contributions to a certain percentage, that’s a real bonus.

If it’s a 50% match, in our example, the employer would have added $50,000 to your total, and you now have $150,000. You will be responsible for paying tax on this extra $50,000 when cashed in, but even after tax, this can be a very nice boost to your retirement savings in itself.

Roth 401(k) Plans

Like IRAs, 401(k) plans also have what is called a Roth option, were contributors do not defer tax on the principal, they instead get the benefit of the distribution of their contributed amounts being tax free.

In our example, just looking at our own contributions, with a Roth we will contribute $75,000 instead of the $100,000, with the standard 401(k), since we had to pay the $25,000 tax on this up front.

Let’s assume we double our initial investment within the plan during our saving years. So the standard 401(k) is later worth $200,000, and all of this is subject to income tax when withdrawn. After taxes, assuming the same rate, we’ll end up with $150,000.

With the Roth 401(k), we double our amount to $150,000 over the years, but no tax is payable on any of this. So in this simple example we end up in the same place. So whether we should be going with a standard or Roth 401(k), or a standard or Roth IRA for that matter, all really comes down to whether we expect our tax rate to go up or down in retirement.

Few people expect it to go up, so standard 401(k) plans remain the most popular. When you no longer receive your employment income, as is the case when you retire, unless you have done extremely well for yourself, it’s usually not the case that this replacement income is going to exceed your employment income.

So you can’t really go too far wrong with the standard 401(k) in most cases, however the Roth option won’t really hurt you, as the only thing you are foregoing is the potential tax savings from having all or a portion of it taxed at a lower rate than you would have paid up front.

Contributing and Withdrawing from a 401(k)

Like IRAs, contribution limits are capped with 401(k) plans, although they are capped at higher amounts. In 2017, individuals under 50 can contribute up to 18,000 on their own, with those 50 and older being allowed an additional $6000, to a total maximum of $24,000. This extra allowance is to allow people closer to retirement to catch up if needed, which is why it’s called the catch up amount.

There is also a total maximum amount that an individual and their employer can contribute jointly to one’s 401(k), which is $54,000, with an extra $6000 allowed for persons 50 and older. The total amount cannot exceed the employee’s earnings, not including 401(k) matching amounts.

This gives you a sense of just how high the employer’s contribution can be in some cases, which can exceed 100% of the employee’s contributions.

The higher the percentage that the employer contributes, the more tempting that these plans should be to employees, and the more they should dedicate putting in as much as they can into it, to get as much extra money as they can from their employers.

When it comes to withdrawing 401(k) funds, while IRAs can be withdrawn prior to age 59 ½ by paying a 10% penalty, 401(k) savings can only be withdrawn prior to age 59 ½ under exceptional circumstances. Once one reaches that age though, then withdraws can occur.

Given the desire a lot of people have for instant gratification, seeking to spend more of their money now and save less, there is nothing that comes close to looking to correct this tendency and get people pointed more on the road to doing the right thing for their retirement than a 401(k).

This is because there is actually a financial penalty involved in not contributing, due to missing out on the employer match of their contributions, and this is often enough to tip the scales between one’s long term welfare and one’s short term gratification, where often people do need this help.

In any case, 401(k) plans do provide even more benefits than this, the potential to pay tax back at a lower rate, the ability to pay tax on income in amounts that have been discounted by inflation, the opportunity to invest this deferred tax and generate a return on it over time, and with a Roth IRA, the ability to earn investment income tax free. So this is very often a wise choice indeed.

401(k) FAQs

  • What is a 401k and how does it work?
    A 401k is an employer sponsored retirement plan which allows employees to contribute to their retirement savings and defer paying tax on contributions until withdrawn from the plan. Contributions grow tax free with the goal of paying less tax on them in retirement.
  • Is 401k mandatory?
    If an employer sponsors a 401k plan, employees have the option of contributing to it or not and how much they contribute to their 401k. Some plans may automatically enroll employees and require them to contribute a certain amount but they must be given the opportunity to opt out.
  • How do I see my 401k?
    Your employer can put you in touch with your 401k plan administrator who can provide you access to information such as your 401k balance, how your money is invested, and more. Many 401k plans also send out paper statements to plan holders to keep them up to date.
  • Can you lose money in a 401k plan?
    401k plans are invested with a longer-term horizon, and usually have a significant portion in stocks which can move up and down in price considerably. The goal is to show a good profit over many years though and these investments tend to make considerable money over this time.
  • What happens to your 401k when you leave a job?
    You can just leave your 401k with the previous employer in some cases, but most people move it to their new employer’s 401k plan if they offer one. You can cash it in but this money is best taken out of the plan gradually due to tax consequences. You can also roll it over into an IRA.
  • How much should I have in my 401k?
    401k plans are designed to provide contributors with extra savings in retirement, at a time where people stop working and see their income decline significantly. The goal is to have enough in your 401k to be able to retire comfortably, although most people fall short of this and should be doing more.
  • Does 401k earn interest?
    401k balances grow in value like all investments do, from the purchase of assets such as stocks which rise in price over time. In a 401k, you also earn on employer contributions as well as deferred tax held in the account. You can also use this to earn interest by investing a portion in bonds.
  • Do I have to invest my 401k?
    401k plans come with various investment options where plan holders can choose what sort of mutual funds they can invest in depending on their objectives and risk tolerance. Some plans offer more conservative investment options but all 401k funds must be invested in something.
  • How much should I put towards my 401k?
    401k plans come with more generous contribution options than IRSs do, $19,000 per year in 2019. Employers usually will match employee contributions up to a certain percentage of income such as 6%, and within that limit, it is wise to contribute as much as you can afford do.
  • When can I withdraw from 401k?
    People generally only withdraw from their 401k in retirement, and ideally you want to be taking money out when you are in a lower tax bracket. Withdrawals before age 59 ½ are also subject to a tax penalty, which should be avoided. There are a few exceptions to this such as if you become disabled.
  • Can my employer keep my 401k?
    Any amount that you have contributed to your 401k is yours to keep. Employer contributions to your 401k may be partially or wholly kept upon the termination of your employment with them depending on whether the contributions have been in there long enough to be considered to be vested.
  • Is it better to have a 401k or IRA?
    If your employer matches your contributions to some degree with your 401k, this makes it clearly preferable to contributing to an IRA because of these additional amounts added. Without these matching contributions, IRAs are preferable because they are more flexible.
  • Is a Roth IRA the same as a Roth 401 K?
    Both 401k and IRA investment plans have a traditional and Roth version. Traditional plans involve postponing tax on contributions and earnings, where Roth plans avoid tax on earnings. 401k’s are employer managed plans where with IRAs the plan holder manages the plan.
Robert

Editor, MarketReview.com

Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.