A 401k plan is a type of investment account offered by employers as part of their compensation package.
It is the first place you should invest anything you are saving for retirement, regardless of when you plan to retire.
You will have the option to invest in many different index and mutual funds, ETFs, stocks, bonds, etc. within a 401k plan. The most important thing is to start investing in your 401k plan now so don’t be overwhelmed by the options.
But Why Save in a 401k Plan?
There are several reasons investing in your 401k should be the first thing you do. Because the investment types themselves are essentially the same as if you were making investments on the open market you need to understand the advantages of a 401k plan over open market brokerage investments:
1. FREE MONEY! Most employers offer a company match of some kind
2. TAX Protection! Pay less taxes by offsetting your taxable income and more.
How do I get free money by saving in my 401k?
Most employers will offer a “match” of the money you save from your paycheck up to a certain amount. This means they will give you free money, in the form of a match, just for saving some of your own money into the 401k.
The amount a company will match varies but it’s always free money you get on top of your regular pay just for saving. Here are a couple common scenarios assuming you make $50,000/year.
- A company offers a full match up to 3%. This means that if you contribute 1% of your 50k, or $500, the company will deposit an additional $500 into your account. If you contribute 3% which is $1,500 the company will match that and give you $1,500 direct into the account. That’s double your money for a total savings of $3,000. That is a huge 100% return on your initial investment right there!
- A company offers a 50% match of up to 6% of your salary in contributions. This is like saying they will give you 50 cents for every dollar you save up to 6% of your total annual salary. So, if you contribute 6% of your 50k, or $3,000, the company will give you $1,500 in matching funds. If you contribute 3% of your 50k, or $1,500, the company will give you $750; that is a 50% return on investment.
- Another option would be some combination of the two above. A company offers to match fully the first 2% of contributions and 50% of the next 3-6% of contributions. This is dollar for dollar for your first 2% of contributions and then 50 cents on the dollar for the next 4% of contributions. If you contribute at least 6%, or $3,000, of your salary; here you would end up getting $2,000 in free money.
At the very least you should always be saving at least as much as a company is willing to match.
This is basically giving yourself a raise of that amount or throwing away a bunch of money if you don’t. Don’t forget that this money will be invested and grow over time, so it has the potential to be worth a lot more.
Ensuring you get the full company match is the least you should be investing in your 401k. But you should be saving even more because of the benefits you get from Tax Protection in a 401k!
What kind of “Tax Protection” do I get by contributing to my 401k?
There are numerous protections you get by contributing to a 401k instead of investing outside of one.
1. Regular Contributions (the money you decide to save in a 401k) are made pretax, so you get the whole value of your earnings.
This means that you actually get the full value of the money you have worked so hard to make, none of it goes towards taxes.
For example: if the government usually taxes your income at 30% that means that you only get 70 cents for every dollar you worked for. But if you invest this money in your 401k, the money is invested before the government taxes it so you get the whole dollar. If you are investing $700 a month in the S&P 500, but not in a 401k, you are missing out on $300 that could have been invested. That is $300 extra making you money through compounding interest while you sleep if you had invested it in an S&P 500 fund within your 401k.
You want to get that full $1,000 that you worked for to work towards your retirement, so you should contribute as much as you can to your 401k to get the pretax advantage.
2. Lower your total taxable income and pay less taxes.
Contributions are made pretax, so by contributing to your 401k you are lowering the amount of money that the government can tax.
For example, if you make 50k/yr and you contribute 19k to your 401k, the IRS will only tax 31k of your earnings for that year (50k-19k=31k).
The IRS will tax you on only 31k instead of on the 50k you made meaning not only do you get the full value of each dollar for your 19k in contributions to your 401k plan, but you also pay taxes on 19k less dollars. In our example this means that you would pay the 20% tax rate for any income over $30k, on only $1k, or $200 in tax, rather than paying it on all $20k you made, which would be $4,000. That is a savings of $3,800.
3. You pay no taxes on any investment gains while your funds grow in a 401k account!
If you are investing in regular stocks and funds outside of your 401k you will pay taxes on investment growth, such as interest and dividends, every year and again when you sell the funds and stocks. That’s basically being taxed at least twice on the same money. However, as long as your money is in a 401k you won’t pay any taxes on it until you start making withdrawals.
Those are the big reasons you should be saving to your 401k through regular contributions. It’s as easy as selecting the amount you want to contribute each paycheck and your employer will take care of it. As a bonus you don’t see that money in your paycheck so you don’t feel like you are losing any purchasing power in your daily life.
WOW 401k plans are AWESOME! What’s the catch?
Well 401k plans are so good at protecting and growing your money that there have to be few restrictions on their use. Restrictions essentially boil down to contribution limits and access to funds for withdrawal. Let’s take a look.
- The first restriction is Contribution Limits. The IRS sets an annual maximum for contributions to these types of plans. The annual contribution limit for an individual filing in 2019 is $19,000. So you can only put $19,000 away, but that’s still a good amount and doesn’t include your employer’s matching funds, YAY!
- You cannot make withdrawals from these accounts without paying a penalty until you are 59 1/2 years old.
- Fees. Most plans will have a small fee for having an account. (Sometimes this is covered by your employer).
- Many 401k plans are used as a retention tool so they have what is called a vesting period. For example, a company may say that a person must work at the company for 3 years before they are eligible to keep any of the company’s matching funds. There are many different types of vesting plans so check with your employer to know when you will be vested to keep the free money. Don’t worry, the money you put in is always yours, only the match is what may have a vesting schedule.
Finally, the money is yours to take with you if you leave an employer, but you can only have one 401k that you are contributing to at a time. When you change employers, you can do what’s called a rollover to move the money from one fund to another.
We use our 401k as our first retirement savings account and max out our contributions each year according to the new IRS limit.
We feel strongly that this is the most important retirement savings option for those who have the option. Because of the reasons we listed above, along with the wonders of compounding interest, we would urge everyone to invest in a 401k plan.
Are you investing in your 401k? If not, what’s stopping you?!
Tips, clarifications, and frequently asked questions
What is Maxing Out Your 401k?
To max out your 401k is to contribute the maximum contribution allowed by the IRS in one year. For example, in 2019 that would be $19,000 in contributions.
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