The 401(k) retirement account is one of the best ways to save for retirement. Unfortunately, living off Social Security just isn’t a reality for everyone, so being able to understand how to use retirement accounts to its fullest is crucial. In this article, I will detail what a 401(k) is, a little bit about the types of 401(k)s, benefits and limitations, and strategies.
What is a 401(k)?
A 401(k) is a type of retirement account that is employer-sponsored. A 401(k) plan is employer-sponsored because it is only offered to employees. This is because money can only placed into your 401(k) account from your paycheck, and some companies offer “matching contributions,” but it is capped to a certain percent. For example, if you are making $100K a year and your employer offers a 3% match, this means that if you choose to allocate $3000 a year from your paycheck to your 401(k) retirement account, your employer will give you another $3000. 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.
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 are not taxed on the money you withdraw. Your contributions can only be made with the money you have after paying income taxes. So this means you don’t pay taxes on any of the money you made while your money was in the account. It is a subtle, but very important distinction. This is very very good, 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.
You may be thinking that the Traditional 401(k) sounds pretty pointless if the Roth 401(k) is so similar, yet is not tax-deferred. 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 pay less taxes. If not, you would want to opt for the Traditional 401(k). In general, more companies will offer a Traditional 401(k) than the Roth, 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.
There is a caveat to the 401(k) plans. Each 401(k) plan has their own tiny little details and such, but in general, you can technically withdraw from your 401(k) retirement account at any time, but you may be subject to a 10% penalty if you are not at least 59.5 years of age. For the Traditional 401(k), this means you’ll be paying income taxes on your withdrawal and another 10% on that! 10% is a lot, so it is a really bad idea to withdraw from your account before you are 59.5 years old. There are some exceptions, like disability or emergencies, but that varies by plan. As of 2019, there is an annual contribution limit of $19,000 for individuals under 50, and $25,000 for those over 50 years of age. The big idea is that you should expect to put your money away for good, until you are about 60 years old.
First off, it is best to invest as much as your employer matches, assuming that there is a match. A match effectively doubles 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 preferrabe 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 100K a year(nice!), and 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 $19,000 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 $16,000 because you would then hit the 401(k) limit.
Essentially, it boils down to:
- 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, which 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.
Ok, 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 are asking the right questions, which is 50% of the way there. If not, that’s fine too. This is the point of reading Financial Literacy Journal articles: to build a sense of 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, leading to less people that need to request for government welfare to retire. 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 a stock 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 tax benefit is that you do not need to pay taxes on the money you withdraw. However, you may only contribute with 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, which 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, and 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. I highly suggest you to bookmark this article and reread this 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.