In part 1 of investing basics, we discussed different types of IRA’s or individual retirement accounts. The second account or investment vehicle used by many Americans is the 401(k). This is an employer-sponsored plan that is offered by many employers. Once again the best source of information on this is going to be the IRS, and it can be found here.
Let’s get into the details.
When people think of traditional retirement savings plans, many are most familiar with the employer-sponsored 401(k). It is one of the primary tools used to save by Americans although it has a relatively short life. The 401(k) plan started in 1978 so its 40th birthday is around the corner. Many employers use to offer pensions to employees as a way to support the retiring workforce and help people sail off into the golden years. This puts tremendous responsibility on the company to make sure that there are adequate funds to ensure a plan is not underfunded and everyone gets the payouts promised. Not many companies offer this anymore for that very reason and instead set up a 401(k) program to encourage employees to invest on their own.
This responsibility now falls on you, and it is important to educate yourself on how it all works. In general, your employer will hire a third party to sponsor your 401(k) plan. The third party is hired with a fiduciary responsibility to support the plan participants aka you. The plan will hire individuals that will look for the best investment choices as they see fit for the employees. Many 401(k) plans today have a selection of mutual funds and target date funds you can choose from. You select the funds you want to participate in and then the allocation you set flows into these investments at the same time you receive your paycheck. If you do not actively make a decision as to what funds you want to invest in but still contribute money to the plan, you will most likely default into a target date fund. Without getting into too much detail, a target date fund looks to the age you plan on retiring and then backs into what your asset allocation should be based on your time horizon.
For most people, if you are offered a company match on the 401(k) plan you should at bare minimum be making sure you are contributing enough to achieve this. A company match is an incentive that your employer provides to you for working it is part of your total benefits package. The catch is every employer is different and offers a different match. It is important to reach out to your HR department or your plan administrator to get this information if you don’t already know. For instance, if your company matches every dollar you defer from your paycheck up to 5% you need to make sure you are contributing at least 5% of your income. Without setting your deferral rate to 5% you are missing out on a huge incentive of your employment. Many people make the mistake of taking this money in their paycheck with the intent of investing elsewhere. This is backward thinking if you are willing to put 5% into your 401(k) you already will have a 100% return on your money. A great long-term rate of return on the stock market is roughly 10% a year, so you are reaching if you think your investments outside of this account will get anywhere close to the guaranteed 100% return offered by your employer.
The one big gotcha of 401(k) plans is they are notorious for having an investment selection with poor choices and high fee funds. This can really start to hurt over the years as Jack Bogle founder of Vanguard explains here. So make sure to visit the expense section of your plans investment choices and make an informed decision.
The traditional 401(k) is set up so you can automatically defer pre-tax money into your plan. This is very similar to the traditional IRA only easier in the case of the 401(k). The tax work is simple you do nothing but set the percentage you are willing to save out of your paycheck, and your employer lowers your taxable income before you ever do your taxes. This is great because without taxes being taken out of your check you are able to invest a larger sum early on in life and let it compound for years to come. The bad news is that there is no free lunch and upon retiring and taking distributions you will have to pay income taxes on the money at whatever your tax rate is going to be at that point in time.
This again is similar to the Roth IRA in that the money added to your plan is going to be after you pay taxes. You will get hit at your current income tax rate, and then the money will flow into your Roth 401(k) account. The good news is that is the end of the taxation, and when you enter retirement, you will be able to take this money out tax-free including earnings on those contributions.
After Tax 401(k)
This is not offered in all plans and not really discussed too often unless you are among a nerdy super saver crowd. For the scope of what we are discussing I will not dive in as I don’t see many people coming to this site looking for this. If you would like to learn more, I can complete an article about this in itself. For now, if you are curious Google mega back door Roth, and consider yourself an official nerd and someone I could have a beer with!
Other Important Information:
- Must be 59 ½ to use funds (savvy ways to avoid this not within scope of article)
- Can roll over the 401(k) or take your pile of money from employer plan when you leave to your personal IRA accounts.
- Hardship withdrawals allowed.
- RMD’s (Required minimum distributions) Even if you don’t want to take a distribution you may be forced to making you pay more in taxes than you would like.
- Max that can be contributed yearly $18,000 not including catch-up amount.
- Max including tax advantaged (pretax & Roth), employer contributions, and after-tax amounts $53,000
As you can see, there is A LOT of information on 401(k) investing, if you are planning on being a company man or women I recommend you educate yourself, so you don’t miss out on the opportunity at hand. Don’t let the details stress you out, the bottom line is you need to be aggressively saving now, and you will watch your accounts grow while gaining confidence and education over the years!
What are your thoughts?
- Do you invest through a 401(k)?
- What investment options does your plan offer?
- Do you invest using the pre-tax or Roth option?