401K Guide and History
Are you contributing to a 401K, IRA or Roth IRA? You should be! This guide explains everything you need to know about these wonderful tax-free wealth building tools.
Definition and History of the 401K
I'll cover the 401k first because that's the one that seems to prompt the most questions. One of the first things I want to stress to you is that employers have handed over the responsibility of retirement planning to you, pension plans are pretty scarce today unless you work for the government and even those are starting to disappear. The sad truth is that most Americans are terrible at long term planning, and many that aren't contributing to a 401K plan will have to work until at least social security age and probably after if they want to have anywhere near the standard of living during retirement that they are accustomed to while working.
When our parents were working in the 50's, 60's and 70's, employers were expected to provide for employees in retirement. If you paid your dues by working for a single employer for an entire career, most would in turn provide you income in your retirement. While pension income might be less than you made when you were working, you could at least count on continued paychecks. This gave people the means to retire even if they never saved a penny.
In the late 70's, congress added a section to the Internal Revenue Code - Section 401(k) in which employees could avoid taxes on dollars contributed to deferred compensation plans. This program was intended for executives but companies were quick to interpret the legislation for their own benefit. The major reason for the explosion of 401K plans is that they allow employers to spend so much less on employee retirement planning. Rather than paying a pension until the retired employee passes away, a 401K plan only requires that employers cover the administration and support costs plus any company match programs during employment, there is no additional expense after the employee retires.
This concept is much easier to grasp with an example. Let's say that Joe worked for 30 years and earned $60,000 per year at retirement and that his employer's policy is to provide a pension equal to 70% ($42,000 per year) of his highest income. If Joe retires and then lives another 30 years, the employer will have to pay him 30 X $42,000 = $1,260,000.
If, on the other hand, Joe's company provides a 401K plan that matches 5% of his income the picture is quite different. For simplicity, let's assume Joe earned $60,000 every year that he worked. Let's say that the company pays $2,000 per year for various 401K plan administration expenses related to Joe's account. In addition, they match 5% of his income, $3,000, in the plan for 30 years. The employer's total liability for Joe's retirement benefits is ($2,000 admin & support X 30 years ) + ($3,000 company match X 30 years) = $150,000.
By switching from a pension to a 401K the company saved $1,110,000. From an employer's perspective, this huge expense savings represents a tangible long term benefit for the company and for shareholders. Oh wait, what about those pesky ethical implications? Don't forget that the average American is terrible at saving money and even worse at investing it and that most people are not long-term thinkers. Not to mention the fact that when you dump retirement planning responsibilities on people that weren't prepared or properly educated, you have just added a huge burden to taxpayers in the future and subtracted value from American society in general nah, we won't worry about any of that. Okay, time to step down off our soap box before someone pushes us, what's done is done and we have a lot to cover.
I'll at least end the history section on a bright note. You can definitely retire wealthy using a 401K if you're properly educated and, luckily, you're on the right track by reading this article.
What you need to know about 401Ks
Here's a break down of what you need to learn into easily digestible chunks:
- Benefits of a 401K
- How it all works (tax deferral, payroll deduction)
- Contribution limits & recommendations
- Retirement Distributions and Hardship Withdrawals
1. Benefits of a 401K
The two greatest benefits of a 401K are that they reduce the taxable income you have to report to the IRS and once money is in a deferred account you can invest tax free until you withdraw the money at retirement. Rather hear that in English than in accounting-speak? Alright, for example, when we say you reduce your taxable income, that means that if you earn $50,000 per year and contribute $5,000 to a 401K you only have to report $45,000 to the IRS when you file your taxes. If you are in a 24% tax bracket, this saves you $1,200 ($5,000 X 24%) in taxes. When I say money in a deferred account is invested tax free it means that you will never pay taxes on capital gains, dividends, coupons payments or any other form of profit. The only time you will ever pay taxes is when you withdraw the money.
What makes stock market investing the greatest wealth-building tool the world has ever seen? Compound interest. While this might sound very "mathy" and boring, I want you to get excited when I talk about compound interest because it's the closest thing to magic you're ever going to see in real life. Albert Einstein once declared that compound interest is "the most powerful force in the universe" and I agree because it certainly has made a lot of people rich. It's a simple concept and is best demonstrated through examples so let's compare a 401K portfolio to a taxable portfolio.
In this example, you're going to contribute $10,000 per year. In addition, you decide to put all your money in index funds so that you can get the average market return which has been about 10% historically. In the 401K plan you will pay zero taxes, in the taxable account we'll assume 24% of your profit is lost in taxes. After 30 years, the 401K will have grown to $1,644,940 (and this doesn't include any company match) and the taxable account will have grown to $1,052,974. The 401K grew 56% more than the taxable account. Albert was right, he must have been a pretty smart guy.
2. How it all works
While I blasted companies for taking away pensions and rolling people into 401Ks in the history section, 401Ks are actually a pretty strong investment vehicle if you take full advantage and work for a company that provides a wide variety of investment options.
Most companies will offer to automatically deduct 401k contributions from your paycheck, you should definitely choose this option if it's available. This saves you the headache of figuring out your taxable income when you file taxes because your W2 will adjust your taxable income by the amount you invested into your 401K. This also means that you don't have to worry about whether or not you have the will power to set aside savings from your earnings. Since it is automatically deducted you'll never see this money in your check, the contributions will go straight to your 401K. About 80% of Americans don't save a penny from their regular pay, so for most of us, automatic contributions into a 401K allow us to avoid the instant gratification spending urge and will-power issues.
Another benefit is that 401K contributions are not a straight line reduction to your income. Huh? This means that if you choose to automatically contribute 15% to your 401K, your paycheck will not decrease by the full 15% because of the tax benefits associated with tax deferred accounts. For example, let's say you earn $50,000 per year and you are taxed at 24%. You will bring home $38,000, right? Now let's say you decide to contribute 15% of your salary ($7,500) to your 401K. Many people assume this means a 15% reduction to take home pay but your take home pay actually only goes down by 11% as a result of the $1,800 tax break you received on the $7,500 you contributed to your 401K plan ($7,500 X 24% tax bracket = $1,800 tax break).
3. Contribution Limits & Recommendations
The next topic is Maximum 401K contributions. In 2008 you were allowed to contribute $15,500. This is the amount that YOU are allowed to contribute. Any company match is not counted against you so technically the maximum contribution is $15,500 + your company's match amount.
How much should you contribute? In our opinion, the old rule of 10% to savings no longer applies, the new minimum is at least 15%. Why? Because the good old US of A ain't what it used to be. You're not as likely to have a pension, the dollar isn't the strongest currency in the world any more, and social security may face reductions in the future since it is the largest expense in the federal budget and will eventually face major solvency problems. Save 10% or less and your lifestyle will be seriously cramped when you try to retire, you may even have to postpone. If, on the other hand, you form the habit of saving at least 15% and invest wisely you should be able to live comfortably when you retire without having to fret over running out of money or every dollar spent.
Typically, companies offer some kind of employee match and you should always take full advantage of this free money. For example, if your company offers a 100% match up to 5% of your salary and you make $50,000 per year, they are basically giving you $2,500 as long as you put at least that much of your own money into the 401K plan. Just like your contributions, the company match goes straight into your tax deferred account. In this example, if you contribute $2,500, they will match and now you have a total of $5000 which means an instant 100% return on your investment. Strangely, many people don't contribute to their 401K and therefore don't take advantage of the company match Are you kidding??? Don't pass up free money.
4. Retirement Distributions and Hardship Withdrawals
When you reach the age of 59 1/2 you can take a lump sum distribution minus a 20% withholding tax, a small price to pay considering all those years of tax free investing. If you don't want the lump sum, you can also choose to either start receiving retirement distributions, which will also be taxed at 20%, or you can leave the money alone. However, at age 70, you will be forced to start taking minimum distributions. Luckily, if you're forced to withdraw, some of these dollars can be rolled into another tax deferred account called an IRA which is covered in detail in the IRA, Roth IRA, and Roth 401K Guide.
The question I dread the most is "can I withdraw money early?" Unfortunately for many people who have made this costly mistake the answer is yes. It is possible to withdraw money and even borrow against your 401K, especially if you meet a hardship qualification, but this is a very bad idea. Every penny you take out or borrow delays your retirement.
However, I want to provide a complete guide so we will tell you that avoidance of foreclosure, medical expenses not covered by insurance, and permanent disability are examples of common hardship qualifications. Even if you meet these qualifications your withdrawal will be subject to a 10% withdrawal tax penalty in addition to your normal tax rate. This means that if you're in the 24% tax bracket and you take money out for any reason Uncle Sam is going to add a 10% penalty and take 34% of your withdrawal in taxes. The Roth 401k will allow you to withdraw funds without paying taxes or penalties, and I will discuss this type of 401K below, but taking money out of your retirement fund is still a BAD idea.
The tax free investing offered in a 401K account is your best opportunity to build wealth and save for retirement. Take full advantage and contribute every penny that you can afford. Also make sure you manage your portfolio diligently, don't leave it up to your planner or your company. We have a large library of free investing information on this site. Please help yourself to as much as your brain can hold and keep coming back until you're comfortable managing your own portfolio. You're always better off when you manage your own money, who else will care as much as you do about your nest egg? That definitely doesn't mean you shouldn't seek expert advice, we recommend that you do, but learn enough to be able to validate any advice that you're getting.