What is a 401(k)?

You just got a new job and your employer offers you benefits, including a 401(k) plan. The name isn’t exactly self-explanatory, and the information they’ve provided you to explain it is probably pretty unclear.

So, what the heck is it, and why would you want it?

Simple Explanation of a 401(k)

A 401(k) is a plan that is designed to help individuals retire. This type of plan is special because the government has allowed all contributions to be tax free. Meaning, you can choose to put away some of your paycheck BEFORE you get your income taxes taken out. This will basically allow you to contribute roughly an additional 20% (or whichever tax bracket you fall into) to your retirement accounts each year.

Although the money you put in is tax free, once you begin taking it out, you will be taxed at the normal rate for your tax bracket. While this doesn’t immediately sound beneficial, it definitely can be, as I will explain later.

It is also pretty likely that your employee will match some of your contributions. Depending on your company, your employer may agree to completely match everything you put into your 401(k), or they may have some other type of agreement in terms of matching. Often, they will agree to match a certain percentage of your contribution (50% of what you contribute) up to a certain percentage of your total pay. This means that for every $1 you put in, they will put in $0.50, up to a certain amount. Many employers will put a cap on their contributions each year, so after you contribute a certain amount, they will stop matching and you’ll be on your own.

Employer matching is where the whole idea of “free money” comes in. You won’t be able to access the extra money that they contribute to your 401(k), but when you retire, you’ll be able to reap the benefits. Contributions made by an employer to your 401(k) are pretty much extra pay on top of your normal salary.

No wonder 401(k)’s are so popular.

Why You Should Consider a 401(k)

If you read the simple explanation, you already know that many employers will match some of your 401(k) contributions. Attempting to reap these benefits is a pretty smart decision for most people. Unless you know some type of investment that can consistently grow at a rate of at least 12% every single year, you should consider investing in a 401(k).

Expecting an average return of 8% from a 401(k) is pretty realistic. Most experts agree that this rate is a totally attainable and common goal. The greatest benefit of this type of plan is that you’re earning 8% on income you earned BEFORE taxes. Basically, you’re earning 8% on 100% of your income, rather than 8% on 80% of your income. As an example, putting $1,000 into your 401(k) will allow us to reasonably assume you will earn $80 (8%) by the end of your first year. In comparison, placing your after tax $800 into some sort of investment that will earn you 8% will end up growing by $64.

This $16 doesn’t seem huge, but over time, compounding interest will continue to make the difference grow larger.

Our example also didn’t take into account our employer contribution. Let’s say our employer will match up to 50% of our contribution, which is a pretty average amount. Now, our 401(k) has $1,500 added to it, rather than the $1,000. Unfortunately, employers won’t often match after tax investments, so you’re still stuck investing that same $800.

Now, your first year will result in the growth of your 401(k) by $120 ($1,500 x 8%). Your investment basically grew twice as much. What will this look like through the future?

I’ll show you!

For more on compound growth, check out THIS article!

That single 401(k) investment will have grown to $32,587 after 40 years, while your alternate investment will have grown to $17,380. Your initial investment essentially was the same amount out of your pocket in both cases. We can say that that same $1,000 you invested in the 401(k) would become $800 after taxes, which is where we get each number. For your 401(k), your employer covered $500, and then you could invest the extra $200 because it was PRE-tax. It’s pretty helpful that something like this exists.

Unfortunately, when you begin withdrawing funds from either investment, you will be required to pay taxes. For your 401(k), you will pay the rate of whichever tax bracket you currently fall into. For our purposes, let’s say 40 years from now you’re earning more money and fall into the 25% tax bracket. The amount you owe if you were to withdraw that entire investment is:

$32,587 x 25% = $8,147

Dang. That’s a pretty good chunk. But in the end, you’re still left with more than $24,000 to spend, all because of that first, relatively small investment of $1,000.

You will also have to pay taxes on the alternate investment, which is known as a capital gains tax. Basically, if you earn more than a certain amount of money each year, any investment gains will be taxed at 15%. After withdrawing out alternate investment, we will have to pay:

$17,380 x 15% = $2,607

Much less than our 401(k) withdrawals! Not too bad. But, now you’re left with a little bit under $15,000. Still pretty solid after you consider that this was originally only $800.

I’m sure you already caught this, but your 401(k) has ended up allowing you to earn an extra $9,000 over the same amount of time, with the same investment. That’s huge considering our initial, one time investment. Imagine the difference after 40 years if you were to invest in a 401(k) every single year for 40 years!

Just kidding, you don’t have to imagine. I did the math for you. If you invest that same $1,000 of your pre-tax income, and receive a 50% employer match every year, you will end up with $124,503 more than if you made an alternate investment.

That’s enough to buy a second house. Or, like, pretty much almost anything else that you want. It’s your money.

Disadvantages of a 401(k)

Your 401(k) is tied to your employer. I’m not sure if this is exactly a disadvantage, but it could be a bit of an inconvenience. If (when) you leave your employer, your 401(k) is also likely going to be affected. There are several options for what you do with your account, but it depends on your employer.

Option 1: Some businesses will simply allow you to keep your 401(k) with them. Pay attention to the details of your plan, or ask human resources, any questions you may have about what leaving entails, as some companies will not allow you to keep your 401(k) with them. However, this is not always the case. Don’t expect the employer contributions to continue if you leave, though.

Option 2: Rollover your existing plan to your new employer’s plan, or into an individual retirement account (IRA). If the benefits of your new job include a 401(k) and some type of employer contribution, I would recommend attempting to move your account to their program. Pay attention to your balance though because it is likely that you will need a $1,000 minimum balance to do a rollover. But, if your new employer doesn’t offer a 401(k), or if you don’t have a new employer, a traditional IRA is your best bet. Traditional IRA’s are a specific type of IRA that also allow pre-tax contributions. This is a big oversimplification, but the benefits of a traditional IRA are very similar to a 401(k). However, you won’t receive employer contributions. In switching to either a new 401(k) or a traditional IRA, your tax benefits are the same and you’re out little to no money.

Option 3: I would say that this is the worst option. You can choose to cash out your 401(k) and take the money. You’ll have to pay income taxes, as well as a 10% penalty for cashing out before you’re 59 ½ years old. You can basically expect to lose 30% of your money this way, and it is no longer growing for the future. DON’T DO THIS.

In my opinion, the greatest disadvantage of a 401(k), as well as a traditional IRA, is the age restriction. While it doesn’t matter how old you are when you contribute, you won’t be able to withdraw from it until you’re 59 ½ unless you’re okay with paying a 10% penalty. So basically, those of us who want to retire early will not want to plow all of our money into this type of retirement plan.

Don’t take this as me advocating against investing in a 401(k), just make sure you think about what your future goals are. I would suggest putting at least a little bit into a 401(k) each year and taking whatever contribution your employer offers.

If you’re 22, you can still expect any contributions you make now to give you back 14 times that amount, after taxes, by the time you’re 60. I would recommend investing in a 401(k), even if it’s a small amount. Shoot for at least 5% of your income per year.

Better safe than sorry.

 

What has been your experience with 401(k)’s? Leave a comment below to share your thoughts!

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