Savings accounts come in many forms, and one of the most popular in the US is the 401(k) plan. It’s essentially a piggy bank that you should not crack open until after age 59 1/2, close to retirement age for most of the workforce which is why it is often viewed as a retirement savings account. To make matters more confusing, it’s named after a tax code, hence a bunch of numbers in the name: 401(k). How it works is quite simple by learning a few fundamentals. And if you work for a non-profit or government agency, most of the following will be true for you too, except instead of a 401(k), you call it a 403(b).
Understanding a 401(k) plan starts with learning how to use it and how not to abuse it. Using it requires being employed by a company that offers a 401(k) plan. This account belongs to you, and you keep it if you leave the employer. A 401(k) relies on a defined contribution, a percentage of your salary (%) that will automatically go from earnings into your 401(k). In many cases, employers will offer a 401(k) match for contributing to the 401(k) plan. You decide how much to contribute, and your employer matches that amount, up to a limit dictated by your employer. So your employer is actually paying you more money than you thought! Isn’t it neat to get an extra $50 or $100 or $200 per month? Just remember though, you have to contribute to the 401(k) in order for the employer to match.
Why use a 401(k) vs. saving at the bank? The difference with a 401(k) is taxation. Money going into the 401(k) is pre-tax, and any growth on that money is tax-deferred. What does that mean? Taxes take a share of any money you make, so as an example, earning $100 really means earning $85, based on a 15% tax rate. However, in a 401(k), that $100 equals $100 going in. If that $100 grows to $150 this year, you keep that $150 in the account, as opposed to taxes taking $7.50 away ($50 growth x 15% tax = $7.50). Keep in mind that this example only illustrates $100. Imagine what this means for $10,000 or $100,000. Now before you go putting all of your paycheck into a 401(k), there is a limit on how much you can contribute each year, set by IRS tax regulations. This year (2019), the limit is $19,000 for the year, with the ability to contribute more if age 50 or older, known as catch-up contributions.
Notice I said that money in your 401(k) is tax-deferred, not tax-free. In a 401(k), taxes take their share when you withdraw money, at your normal tax rate. But the important thing is that your money had more potential to grow because taxes did not eat away at every cent along the way. Thus, the 401(k) is known as a tax-advantaged account, a special type of savings account.
How does growth happen in a 401(k)? Through investing! Often people confuse a 401(k) with the stock market. True, you can place stocks in your 401(k), but stocks are not the only type of investment you can have. Going back to a former lesson when we talked about planting seeds, the 401(k) is just a flower pot, and you get to decide which investments, or seeds, to grow inside. Most employers limit your investment choices to a few, so that you are not overwhelmed by the options.
A 401(k) is not always used as a retirement savings account. Let’s discuss some possible pitfalls with the 401(k). Try to avoid the following:
- Early Withdrawals. If you withdraw money from your 401(k) before you turn age 59 1/2, you not only pay the taxes owed, but you also get penalized an extra 10% on your withdrawal. That diminishes your earning power.
- 401(k) Loans. Some 401(k) plans allow you to take a loan. But borrowing from a 401(k) means you lose out on the time that your investments could be growing. Time is something you cannot buy back.
- Not Capturing Full 401(k) Match. Although you could argue that any contribution to the 401(k) is still savings, not capturing the full employer match is a loss for you. To view it from another angle, if your employer let you choose between $50 more or $100 more per month, and neither option required you to work more, wouldn’t you choose the $100? That’s the same as capturing full 401(k) match!
There you have it! The 401(k). It may seem like a lot to absorb, but just think of the flower pot, and you are well on your way to being an ace at the 401(k)!
Homework: Take a look at your 401(k). Are you capturing full 401(k) match from your employer? Parents can start kids young with a savings match! Learn more by clicking here.
Ace Academy will skip next week’s lesson in observation of Thanksgiving holiday and resume the following week. I also want to take this moment to thank you for reading!