If you are a working professional you have probably heard of a 401(K), but my guess is nobody ever really explained the details of this incredible employee benefit. This likely caused you not to take full advantage of this amazing perk. In this article I will take you through exactly what a 401(K) is, where the money goes, the benefits and drawbacks, and lastly a little guidance of how much you should invest in it.
A 401(K) is an employer sponsored retirement account that employees can deposit money into each paycheck for retirement. Employers started offering these plans because pension plans became too expensive to maintain. I would explain what a pension plan is, but so few people receive them it would be a waste of time. The reason it is called a 401(K) is because that is the section of the tax code that governs these accounts.
The money that you put into these accounts usually gets put into a mutual fund, specifically a target-date fund. A target-date fund is a fund with a combination of stocks and bonds that becomes more conservative as the employee reaches the target-date (usually a year of planned retirement). But depending on your employer’s plan you might have many options or very few. If you are unsure where to invest the money I would see if your company has financial advisors, you can talk to.
The reason a 401(K) is such an amazing and in my opinion necessary part of any retirement plan is because of its tax benefits. The money that you put into the account gets deducted off your paycheck before you pay taxes, so it effectively lowers your taxable income. For example, if you max out your 401(K) contribution (will get to that later) the amount of money you save on federal income taxes would be approximately $3,500 to $4,000, depending on what tax bracket you are in. That alone is an amazing benefit, but a 401(K) has one more tax trip up its sleeves. All the money earned in that account through dividends and capital gains are not taxed either. Another example to really knock your socks off. If you maxed out your 401(K) for 35 years and the money grows 10% each year (read my S&P 500 article if you are wondering where that number came from) you would save $1 million dollars in capital gains taxes! You read that right $1 million dollars, if I did not have your attention before I am sure I do now!
If some people reading this are a little skeptical after that last section, I do not blame you. I am going to go through some of the drawbacks of the 401(K). The biggest drawback of a 401(K) is the limited access you have to the money in the account. You do not have the ability to take money out of this account until 59 ½ without having to pay a penalty and income taxes. (There are some exceptions). The next drawback on a 401(K) is that you must pay taxes on your withdrawals from the account once you reach retirement and this money is taxed as income. Because you did not pay taxes on the money when you put it in Uncle Sam wants his cut when it comes out. However, the thought process is in retirement you will be making less money because you will ideally have less financial responsibilities. This would cause you to be in a lower federal income tax bracket. So, I do not think this is really a drawback, but it is something you must be aware of.
Another thing that is synonymous with 401(K)’s is the company match. This is additional money that your employer adds to your 401(K) based on your contribution.
Company A will match $0.95 to every $1, up to 5% of the employee’s salary.
Company Match Percentage: (.95*1)*5 = 4.75 %
Employee Contribution: $65,000 * .05 = $3,250
Yearly Company Match: $65,000 * .0474 = $3,087.50
This is essentially free money that your company is giving you, if you contribute to your retirement. However, the biggest caveat to the company match is usually companies will require you to stay with a company for a certain amount of years before this money is completely vested. This means you must stay with the company for a certain amount of years to have access to the company match money, if you leave the company you lose access to the company match money.
If after reading this, you are super excited about 401(K)’s and you are like Husk how much should I put in this account sounds amazing!? My response to that would be it depends on your financial situation. If you have student debt, mortgage, kids on the way, etc. that needs to be taken into consideration . Because remember the money that goes into this account cannot be taken out (easily). So, I would make sure you have a good emergency/adult savings fund (check out my article on savings accounts) built up before contributing too much into this account. But all that being said I think the minimum you should be putting into this account is enough to meet your company match. Not meeting the company match is essentially saying no to free money. But if you have money to burn and you have been waiting to find a place to put it; the maximum amount you can put in a 401(K) is $19,000 per year. I know for some that seems like a crazy amount, but I promise you every little bit you can contribute to this account you will thank me in your retirement.
I know this was a lot and I am sure some people reading this have questions. If you have any specific questions or want to know more send me an email at firstname.lastname@example.org!