Understanding Your 401(k)
Being smart about investing can befuddle even the most financially savvy among us. But when it comes to understanding your 401(k), there seems to be a special confusion, reserved just for this particular type of retirement investment.
Let's see if we can demystify the 401(k) once and for all, so you can get on with better things. Who knows, you may also feel the need to change what you're doing with your own 401(k) plan.
401(k) Basics
A 401(k) plan is basically a retirement plan offered through your employer- there are other names for them, depending on what type of employer is offering them:
- 403(b) plans are offered by nonprofit organizations and public education employers
- Thrift Savings Plans (TSP) are offered to federal workers
- 457 plans are offered to state and municipality employees and some nonprofit organizations
Whatever you call them, and whomever you work for, the principle is the same: your employer holds money from your paycheck and it goes directly into your retirement plan. You never see the money, and as a result it's not taxed (until you use it later on in retirement).
How Does the Money Get Invested?
401(k) plans are set up and managed by employers. They will offer their employees a limited range of investment options to choose from, then will manage the money for them, often through a financial institution such as TIAA-Creff or some other well-known company.
Even though the employer manages the account for you, you are the owner of the account. That way, if you leave your job, your 401(k) stays with that financial institution and you still own the account.
There will be some choice as to how you'd like your retirement money to be invested through your 401(k). However, your choices will more than likely be limited, especially compared to the choices you would have if you went directly to a financial institution to start up an IRA, for example.
The Great Perk: Matching Contributions
One great thing about 401(k) plans is that you are contributing pre-tax income. The tax savings can be significant. You can reduce your taxable income by as much as $18,000, which is the 401(k) limit for 2016. If you are age 50 or older, you may contribute an extra $6,000 for 2016.
You may also contribute to a special 401(k) where you DO pay income tax on your contributions, but you get to withdraw during retirement on a tax-free basis.
The second great thing about 401(k) plans is that many employers (but not all of them) offer what's called "matching contributions". For every dollar you put in your retirement plan, your employer will kick in fifty cents. It's free money!
However, there's a limit on this free money from your employer. Companies who offer matching contributions generally pay one percent to six percent of your annual salary. So, if you make $100,000 and you've chosen to contribute six percent of your income to your 401(k), that's $6,000 from you.
If your company match is 50 percent, they'll contribute $3,000 on your behalf. Many companies stopped offering matching 401(k) contributions when the economy took a turn for the worse in 2008, although some have reinstated them since then.
Fees for Your 401(k)
The financial institution which holds your investments isn't managing your money for fun. They charge fees, just as they do for all their other financial products, and at similar rates. You can expect a one percent or 1.5 percent annual fee, based on the balance being managed by them.
Some funds will have higher fees, and some will charge more for add-on services such as target date funds.
Early Withdrawal From Your 401(k)
All that money sitting there, growing and growing over the years can look pretty tempting when you need money. There are provisions for early withdrawal, but you'll pay fees and you'll also have to pay taxes on the amount you take out.
The penalty for early withdrawal from your 401(k) is 10%. That means if you siphon off $10,000 from your retirement account, you'll pay $1,000 in fees, then possibly another $2,000 to $3,000 in taxes.
401(k) vs. IRA
Because 401(k) benefits have all but disappeared in many companies, more people have taken their retirement savings into their own hands. One way to do that is with an individual retirement account (IRA).
The difference of course is that with an IRA, you can choose any financial institution you want for handling your retirement money. Plus, you may choose any funds they have available, whereas with a 401(k) you may be limited to just those your company has chosen to include in their plan packages.
But the contribution limits on an IRA are far lower than a 401(k), so if you plan on contributing more than $5500 (the 2016 Roth IRA maximum contribution allowed by the IRS), the 401(k) allows for much higher contributions.
If you're a super saver, you may contribute to both your 401(k) and your IRA. Max them both out for a total of $5500 + $18,000 = $23,500 (even more if you're over 50).
If you do choose to start a 401(k), plan to stay the course, even when the market takes a dive or the economy turns sour. Pulling out because of panic, or withdrawing to use the money for something else (like a mortgage or for paying bills) negates the benefits of contributing to your retirement account. This goes for your IRA, too, by the way.
Recap
The bottom line? A 401(k) is a great way to save for retirement, but especially if your employer offers matching contributions. If they don't offer the matching contributions, you may find there are more retirement savings investment options elsewhere.
A retirement account you open independently of your employer may come with more options, lower fees, and better terms, so shop around. A financial advisor can help you sort out all your options. Otherwise, take full advantage of those matching 401(k) contributions if you can, because you're lucky to have them!
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Aaron Hatch, CFP® is the Co-Founder and CEO of Woven Capital a fee-only financial planning and investment management firm that serves clients nationwide. Based in the far Northern California city of Redding, Woven Capital specializes in helping small business owners, entrepreneurs and physicians navigate their biggest financial hurdles to make smarter decisions with their money. Aaron and I became friends after meeting at a financial planning conference geared toward Gen X & Gen Y advisors and I asked him to write some thoughts on 401K plans as a guest topic for this site. |
Aaron Hatch | Woven Capital