What the Heck Is a 401(k)?

You’ve undoubtedly heard it many times, “Invest in your 401(k), or you’ll regret it!”. Well, they’re definitely not wrong. But we don’t tend to want to do something if we don’t know what it is, or how it works.

So let’s dive into the basics of a of 401(k) plan and learn why you need to start investing in your future, today!

The Basics

Firstly, let’s get the easy questions out of the way, like what the heck does 401(k) even mean? When I was a kid, I used to think 401(k) meant putting money away for retirement until you had $401,000 (hence the “k”). Yeah… I wasn’t the sharpest tool in the shed.

The 401(k) refers to a retirement plan that is only available from an employer. It allows a business to set aside (or in Banker Speak, “defer”) a part of an employee’s paycheck, before the big bad IRS comes to reap their share. After your money is set aside it’s given to an investment company (such as Wells Fargo) to be safely invested for you.

Putting some of the responsibility of retirement on employers was a way to ensure people invested in their future. This was a win/win for the financial system, as it would help safely, and securely, allow people retire. At the same time, it would prevent our social welfare system from collapsing because of people retiring with no investments (or so we thought).

Did you know? The 401(k) was a sort of “loophole” that was added to the tax code in 1978, and discovered by retirement consultant Ted Benna, in 1981. His creative, uh, “use” of the IRS code began the definitive retirement plan of the modern era.

What’s so great about a 401(k)?

Your money is being invested, fantastic! But why all the hubbub? What makes a 401(k) special?

The biggest advantage of a 401(k) is that whole pre-tax thing. Pre-tax means your money was “rescued” from the IRS (or as I like to call them, The Reapers), before they’ve gotten their claws on it. Again, you’re probably asking yourself “why is that such a good thing?!”.

Think of it like a one-two punch to the IRS.

First, any of your money going into a 401(k) isn’t being taxed… yet. This immediately turns a potential $1000 investment into (roughly) $1250. Secondly, is the fact that this money is “removed” from your total income. Less income means less income taxes, and possibly a lower tax bracket for you!

Here’s an example that will probably still leave us confused:

Let’s say you make $50,000, with a tax rate of 25%. That’s $12,500 you would have to pay in taxes.

Instead, let’s say you contributed $15,000 into your retirement plan. Now you only need to pay income taxes on $35,000, which would be $8,750. What do all these numbers mean for you?

  • You didn’t lose $15,000, you’re investing it
  • You saved $3,750 from being eaten by taxes

What are you going to gain from all this? In 30 years one contribution of $15,000 would become (give or take) $50,000. Do that every year? You’re looking at nearly $2 million for your retirement.

As of 2018, you can make a maximum of up to $18,500 into a 401(k). With an extra $6,000 if you’re over 50 years old, as a sort of “catch-up” system.

Employer Matching

Many employers will match your 401(k) contributions. There’s no standard, so whatever they match is entirely up to them. Now, do you know if your employer does matching? If it does, stop what you’re doing, and go cap it out!

Employer matched retirement plans are 100% free money that you’re tossing down the drain if you’re not taking advantage of it. Their matching contributions can easily add up to hundreds of thousands of extra dollars over your work life. Seriously, go do it!

The maximum an employer can contribute is $54,000, or 100% of your salary. Whichever is less.

Traditional vs Roth

Up until now we’ve been talking about the standard or “traditional” 401(k), as it’s the most common plan people deal with. So what exactly is a Roth 401(k)? Here’s the basics:

  • A traditional 401(k) is only taxed once, when it’s cashed out. If you take money from it before 59 ½ years of age, it will be hit with a 10% penalty by the IRS, on top of taxes.
  • A Roth 401(k) is taxed immediately when making a contribution (but still only once), just like regular income. There’s no penalty when taking funds from a Roth account, and when you decide to cash in, there are no taxes to pay.
illustration of a see-saw graph showing the difference between traditional and roth IRA

Basically, if you’re deciding between a traditional or Roth 401(k), you need to ask yourself two questions.

  • Are my taxes going to be lower when I retire? Go with a Traditional 401(k)
  • Are my taxes going to be higher when I retire? Go with a Roth 401(k)

What’s better for me?

No friggin’ clue what your taxes will be? Consider your current and future job situation.

Roth accounts are great for people who think they’re going to have a very large income in later years (think doctors, lawyers, etc…). Especially if you have investments (such as stocks and bonds) or an inheritance that will skew your income, pushing you into a higher tax bracket.

If you’re still unsure about that and don’t want to put your faith in just one, then don’t! Feel free to split your investments 50/50 (or however you want) into both options. That’s right, you’re not stuck with just one retirement account!

If you do open multiple accounts, keep in mind that you can’t exceed the total contribution limit – $55,000 as of 2018 – which includes all retirement plans you’ve contributed to.

Some extra tidbits

  • Your 401(k) is creditor insured. This means your investment completely protected from the IRS in the event of a foreclosure, bankruptcy or collections. This does not mean it’s federally insured (protection from market crashes).
  • If you leave your job after 55, you may have the option to cash out your retirement and not pay a 10% penalty fee, instead of waiting until 59 ½. Keep in mind, if you decide to roll it into an IRA instead, you’ll forfeit the option to cash out early.

TL;DR

As with every smart financial decision, you’re always going to be on the winning team. By investing in your 401(k) (or other retirement plans) you’ll have made a giant leap towards your future prosperity. Better yet, it’s super easy, secure, and (mostly) risk free.

You’re saving a significant amount of money from going to the IRS. Likewise, you might be getting 100% free money from employer matching contributions. Last but not least, you’re making it grow in a bulletproof investment. I like to think of it as a win / win / win.

Did I mention you should cap out your employer matched 401(k) right now? Go do it!

Want to learn more? Let’s take a look at the magic of investing – Compound Interest.


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