If you happened to doze off during the countless new-hire orientation sessions upon hire, you now might suddenly find yourself lost when signing up for a 401(k) plan.
To those without a financial background, the idea of investing for retirement may seem like a complex world full of statistics and foreign vocabulary. No need to worry, we have you covered with these answers to common 401(k) questions.
1. What is a 401(k)?
A 401(k) is a tax-advantaged, defined contribution plan that is usually offered to employees on behalf of their employers. Defined contribution describes the fact that a 401(k) account does not have a promised payout upon retirement, and instead the amount contributed to the account is decided by both the employee and employer.
At the most basic level, a 401(k) is a retirement savings vehicle that allows both employees and their employer to contribute to an account that can be invested in a way to hopefully battle inflation and maintain future purchasing power.
2. How is this funded?
Employees contribute to this account directly from their paycheck. You can choose either a percentage of your salary or a dollar amount from each paycheck that will be sent to your account automatically. This amount can be changed but it’s good practice to ask how often payroll changes can occur. Generally, these regular contributions can only happen through payroll. In other words, if you’re hoping to invest into a 401(k) plan from your checking account, you will likely be unable to.
If you happen to have an existing 401(k) balance from a prior employer, many plans will allow you to rollover this amount into your new 401(k) account. This will essentially combine your old account with your new account.
Besides your own contributions, employers often contribute on your behalf to your account. This can be in the form of a matching contribution, or a percentage of your salary. This 401(k) “match” is a terrible thing to let waste. A general rule is to always contribute enough to take full advantage of your employer’s matching contribution, otherwise you are essentially missing out on “free-money”.
3. Choosing between Traditional and Roth contributions
Upon creation, you will be asked to choose between a “traditional” or “pre-tax” account and a “Roth” account. As you may have guessed, this decision asks you to determine how you want to be taxed. Taxes, are you bored yet? Let me try to break it down as painlessly as possible.
Traditional accounts: With a traditional account, the contributions from your payroll will be made with dollars that have not be taxed. Since Uncle Sam needs their fair share, when you take money out of this account in retirement years, you will be taxed at ordinary income rates at that time.
Roth accounts: On the other hand, Roth accounts are the opposite. Your contributions coming out of your paycheck will be taxed at ordinary income rates now, but not down the line when you withdraw money from your account.
When choosing between these options, it is important to understand that every individual situation is different and specific decisions can be made with the help of a tax professional. However, most advice begins with one question: do you believe that your tax rate will be higher or lower in the future when you retire?
4. How is this account be invested?
In order to maintain purchasing power, investing your 401(k) balance is important. Although your investment options may seem endless, many plans allow pre-allocated portfolios or target date funds to simplify your choice. A pre – allocated portfolio will select a mix of stocks and bonds that are generally well diversified and allow for automatic rebalancing to maintain your selected allocation. Target date funds allow you to select your projected retirement date and are designed to provide a simple investment solution through a portfolio whose asset allocation mix becomes more conservative as the target retirement date approaches.
So, what should you keep in mind when selecting an investment strategy? Generally, the most important factor is the amount of time that you have until retirement. The longer you have, the better your ability to overcome short-term market fluctuations and take advantage of long-term returns that typically result from taking a higher long-term risk. Another important factor is your tolerance of risk, or peace of mind. If you tend to become worrisome during market cycles, it may be beneficial to choose a more conservative portfolio.
5. Vesting schedules
An often-overlooked characteristic of a 401(k) account is a vesting schedule. Vesting can be defined more simply as ownership. This means that you will vest or own a certain percentage of your account balance, that usually increases on an annual basis based on the amount of years worked at the company. Below is a standard 2 – 6-year vesting schedule as an example, note that not all plans follow this:
|Years of service||Vesting %|
So you may be wondering – why should you contribute to an account that you don’t have full ownership to? Great question. All employee deferrals, or in other words, contributions from your paycheck, are immediately 100% vested (you have full ownership). The vesting schedule pertains only to certain contributions that come from your employer. It is also important to know that some employer contributions are also 100% vested, especially if the plan falls under “Safe Harbor” rules.
Before withdrawing from your account balance, it is important to understand the high-level rules and limitations. Below is a list to keep in mind:
- Age 59.5: If you withdraw from your 401(k) account prior to turning 59.5, you can expect to receive a 10% penalty on the draw. This is on top of any relevant income tax liability.
- Rule of 55: Upon termination of employment, you may be able to avoid the 10% penalty if you are 55 years old.
- In-service withdrawals: Some plans allow an employee to withdraw from their balance after age 59.5 is attained, even if they are still working for the company or “in-service”.
- Required minimum distributions: Upon turning age 72, you will be required to take mandatory withdrawals from your 401(k) account annually. The amount is decided based upon age, the size of your balance, and the IRS life expectancy table.
- Rollovers: You will also have the option to “rollover” or transfer your balance to a new 401(k) or Individual Retirement Account (IRA) if you happen to terminate employment with your employer.
7. So what? Why is this important?
Now more than ever, the responsibility of saving for retirement has fallen on individuals. Although certain social nets like Social Security and Medicare are intended to provide assistance for retirees, it will not be enough. According to the Social Security Administration, its payments replace roughly 40% of the average wage earner’s income after retiring1. This, combined with the uncertainty of Social Security funding are great reasons to utilize your 401(k)
Additionally, the impact of compound interest is incredible. Although you may have heard this buzzword over and over, compound interest allows you to earn on top of your earnings. Your money and contributions are literally working for you! Still don’t believe me? Check out the below illustration and see for yourself:
For example, Participant A and Participant B are the same age and earn the same amount of money. They each invest $115 every two weeks to a hypothetical plan with an 8% average annual return, compounded every two weeks.
Participant A invests $3,000 a year from age 30-39, which means putting $30,000 into a 401(k) over 10 years. Participant A retires with $321,443 or $62,391 more than Participant B.
Participant B invests $3,000 a year from age 40-65, which adds up to a total of $78,000 in the 401(k) over 25 years. Participant B retires with just $259,052 despite contributing more money.
(This hypothetical does not include the deduction of investment advisory, transactional or other fees, the incurrence of which would materially reduce the returns shown. Typically, money you take out of your plan is subject to ordinary income tax and, if applicable, to an additional 10% federal tax penalty on early withdrawals. All investments are subject to risk of loss. As such, actual investors may experience materially different results.)