The 401(k) Basics

Last updated: July 23, 2021

Basics:

There are many avenues with saving money for retirement. One option is the 401(k). Many companies offer 401(k)’s for their employees.

The process is quite simple! If you are not sure your company offers a 401(k), ask your manager or human resources representative. If you do not have a 401(k) option, there are different avenues which you can take advantage of that I will touch upon in future blog posts.

Based on the 2021 tax code set by the IRS (contribution limits unchanged from 2020), the maximum annual contribution to a 401(k) is $19,500 if you are under 50. If you are over 50, you are given a “catch-up” opportunity of an additional $6,500 for a total maximum contribution of $25,000 annually. As a note, no you cannot contribute above this amount set by the IRS. Source: Retirement Topics – 401(k) and Profit-Sharing Plan Contribution Limits | Internal Revenue Service (irs.gov)

401(k) Setup:

As a new employee or even current employee, you can choose to do pre-tax dollars that gets put into the 401(k) plan or after-tax option referred to as the Roth 401(k). When you are setting up your account, you can choose a target date retirement option, which automatically selects a fund with a year. This year is when you would aim to retire (this is based on your age/year you were born). As you get closer to retirement, the target date funds become more conservative by owning less equities and more bonds and cash.

If you do not want to have a target date option, there are other investment choices in your investment plan such as cash, bonds, or stock funds. If you choose these individual investments over the target date funds, make sure you review the historical returns and cost! You cannot expect to double your money very quickly if the fund historically only provides a modest 2% return!

Remember this, the higher the return the higher the risk. If you can stomach ups and downs in the market, then you are risk taker, if the opposite and you are more risk adverse or conservative, target dates are great to set it and forget it!

When you set up your 401(k), as mentioned previously, you allocate a percentage of your salary/income to be invested in the stock market. Some people recommend 10%, I think closer to 15% as the goal, but anything is better than nothing! There is a nice feature to add an auto escalation on your future contributions, where every year you contribute, say 1% more to your 401(k). The purpose of all these features is that you are investing more for your retirement and achieving your financial goals. Time in the market is more important than timing the market. Invest for the long term!

Also, make sure when you are logged into your account, add a beneficiary and a contingent beneficiary. It may seem unnecessary now, but it does not hurt to have it done. You never know what happens in life. Just in case you die and your beneficiary passes, you want to make sure the money goes to someone.

401(k) Pre-tax vs. Roth 401(k):

You can contribute pre-tax dollars in your 401(k) account. You take the money out of your paycheck pre-tax, which lowers your taxable income, but the downside is that you must pay taxes when you take the money out at retirement. The taxable income can benefit you if you are wanting to lower your taxes owed today. On the other hand, the Roth 401(k) is when your contributions are taken out of your paycheck after taxes. While you pay more taxes today, you do not pay taxes ever again – this means your Roth 401(k) not only grows tax-free, but when you take money out in retirement, you will not owe taxes on this amount!

Here is an example:

Assume at a 20% tax rate, Jack is making $48,000 annually. Jack would be taxed 20% on $48,000 and would take home $38,400 after taxes annually. If Jack were to contribute 10% of his paycheck into a 401(k) pre-tax, he would contribute $4,800 annually, which lowers his taxable earnings from $48,000 to $43,200. This results in less money being taxed annually.

You also can do post-tax or Roth 401(k) in your retirement plan. This is where you pay taxes on your income now, and then the contributions you make to your Roth 401(k) are TAX FREE. This means all earnings are also TAX FREE. You pay more in taxes now, but reap the benefit of tax free compound growth! If you are young and looking to invest for a long time horizon, your earnings are not going to be as high now, as they will hopefully be in the future. If you assume, you are paying 20% tax rate now on your earnings, in the future with raises, etc. you might be paying 30% tax rate when you retire. By taking advantage of the Roth 401(k) you can save lots of money long term and at retirement.

401(k) Growth Potential Example:

Please note this is purely an illustrative example and not investment advice.

Option 1.)

Jack makes $48,000 annually. 401(k) savings is pre-tax 10%.

Monthly Jack is saving $400/month or $4,800 per year

• At a 5% annualized growth rate, in 10 years, Jack will have $60,373.88 ($48,000 contributions, $12,373.88 in interest/appreciation).
• At a 5% annualized growth rate, in 20 years, Jack will have $158,716.58 ($96,000 contributions, $62,716.58 in interest/appreciation).
• At a 5% annualized growth rate, in 30 years, Jack will have $318,906.47 ($144,000 contributions, $174,906.47 in interest/appreciation).

Option 2.)

Jack makes $48,000 annually. 401(k) savings is pre-tax 15%.

Monthly Jack is saving $600/month or $7,200 per year

• At a 5% annualized growth rate, in 10 years, Jack will have $90,560.83 ($72,000 contributions, $18,560.83 in interest/appreciation).
• At a 5% annualized growth rate, in 20 years, Jack will have $238,074.87 ($144,000 contributions, $94,074.87 in interest/appreciation).
• At a 5% annualized growth rate, in 30 years, Jack will have $478,359.70 ($216,000 contributions, $262,359.70 in interest/appreciation).

By simply investing over the long term in either example, Jack will have a nice nest egg when he retires. Consistent and long term investing will help make retirement possible. Are you able to save an extra 5% now? Because over a 30 year time horizon, Jack would have over $159,453.26 more dollars! Please note that Jack will have to pay taxes at retirement if he only contributed pre-tax dollars.

Try it out for yourself and see how much you could save: https://www.calculator.net/investment-calculator.html

401(k) Distributions, Loans and Commonly Asked Questions:

Can I take my money out? Can I take a loan? What is an RMD? Should I cash out my retirement account? I am changing jobs, what should I do with my 401(k)? All these questions are very common as we can easily face them with life changes and challenges.

Can you take your money out?

Short answer, yes, but there is a cost. The cost is taxes. The IRS does not like it when you take money out of your 401(k) in the form of a distribution. If you are under 59.5 years old, not only do they tax you at your current tax rate, but you will be penalized an additional 10% as an early withdrawal penalty! Furthermore, the distribution is considered income, which could significantly, increase the tax bracket you are paying, resulting in even more money paid to the IRS, and less for you…

Can I take a loan?

Yes, and they make loans quite easy. You can take general purpose loans or residential loans on your 401(k). Depending on the 401(k) features, you can have 1, sometimes 2 loans outstanding. The maximum loan set by the IRS is 50% your account value or $50,000, whichever is greater. For example, if you have a 401(k) balance of $45,000, the maximum loan you would be able to take is $22,500.

When you take the loan, you have a set schedule of repayment and the money is taken out of your paycheck, plus interest to yourself. It is an avenue if you need funds, but remember that money not being invested, will not grow and compound!

The last note regarding 401(k) loans is regarding outstanding loans and if you leave your employer or were separated from employment. If you have a loan outstanding the remaining balance becomes due. If you do not pay, then the IRS considers this a distribution, and you would be taxed and possibly penalized the additionally 10% if you are under 59.5 years old.

What is an RMD?

An RMD or Required Minimum Distribution is a requirement set by the IRS to withdraw your money from your 401(k) based on your age. This is money you must take out of your retirement account. Based on the current rules, you are forced to begin RMDs at age 72. You do not have to spend this money! But they (the IRS) make you take it out. If you forget… the IRS will make you pay a 50% excise tax on the amount you did not distribution/withdraw. PLEASE, DO NOT FORGET. Also, do not forget you will have to pay taxes on all distributions as it is treated as income!

The IRS has some great worksheets which I have provided the link below to help figure what your annual RMD will be each year. If you have any questions regarding RMDs and the process, the IRS website provides great resources. Additionally, I will provide more clarity surrounding RMDs in future blog post.

Try out the IRS RMD worksheet: https://www.irs.gov/pub/irs-tege/uniform_rmd_wksht.pdf

Should I cash out my retirement account?

No. Unless you are faced with bankruptcy and have no additional options, the 401(k) should not be cashed out. The tax ramifications will be absurd. No, just no.

I am changing jobs, what should I do with my current 401(k)?

There are a few avenues you can take:

• Leave it be
• Rollover these funds into an IRA or individual retirement account
• Rollover these funds into your new 401(k) plan
• Take a distribution

As I mentioned in the question above, you should not take a distribution, as the taxes would be extremely high.

There is nothing wrong with leaving your 401(k) at an old employer, it just can get confusing if you leave places here and there, as you might forget where your money is located!

You can open an IRA or individual retirement account at any brokerage firm where you can invest the money as you choose. The upside is the flexibility, the downside is you are in control. Once you tell your current 401(k) provider that you want to rollover your money into an IRA, they will send you a check and you have 60 days to send this check to your new IRA provider. DO NOT FORGET THE TIMELINE. If you do not send the money in time, they will count this as a distribution, and you will be heavily taxed by the IRS. If you have questions, contact the retirement provider or speak to your accountant.

Lastly, and the most recommended option would be to take your 401(k) and request a rollover, but you will have this money sent to your new employer’s 401(k) plan. By doing this option, you will always know where your money is located, and you have more money in one place to compound and grow long term! The process is similar to opening and moving funds to an IRA, but you would be sending your money from your old 401(k) provider to your new 401(k) provider.

Stay focused. Get started by saving for your retirement. The best time to start is today. Green light into the sunset for retirement! Investing consistently over a long time horizon will give you the largest financial advantage. Your financial future is up to you and only you. What are you going to do about yours?

Until next time!

Zach