You’ve just graduated college, you’ve been on the job hunt for six months and finally, you’ve landed your first “adult” job.
You show up on day one and start filling out a bunch of paperwork for drug tests, employee agreements, and other super wordy procedures full of “corporatese”.
Then the head of HR hands you a packet with “401K” on the front cover and asks you if you want to sign up.
You vaguely remember your parents saying something about a 401K, but you’re not sure what it is, so you tell HR that you’ll read over the packet and let them know.
You head back to your cube and open the booklet and it looks something like this.
Your head explodes.
The booklet’s 50 pages long with size 7 times new roman font (didn’t that die along with Windows Vista)?
You’re overwhelmed with information, so you toss the book in the drawer of your cube and vow that you’ll deal with it later.
But then 3 months go by.
Then 6 months.
Then a year.
And you still haven’t even signed up for the thing.
Which is crazy, because you may as well be saying “na, I don’t need free money”.
But I get it. I really do.
This is all extremely overwhelming and we’ve seen our parents get burned over and over again by stock market crashes. So we’re nervous and don’t want to mess it up.
Luckily, 401Ks aren’t as difficult to understand as they seem.
Yes, it’s all a bit overwhelming at first, but it’s totally understandable.
So let’s dive in.
What Is A 401k In Real People Terms?
A 401K is a tax-deferred, employer-sponsored, retirement account.
Let’s break that down.
Retirement Account: A 401K is a special type of investment account that is specifically designed for retirement. It’s important to recognize that a 401K is not an investment. Instead, it is a house that holds all of your investments like stocks, bonds, and mutual funds. I’ve talked about retirement accounts before, and specifically the IRA (individual retirement account). Be sure to check out this article for an in-depth explanation of how retirement accounts work.
The bottom line here is that a 401K is an account. Just like a checking account or savings account, it’s just an account that holds things. In this case, it holds investments.
Employer Sponsored: This just means that 401Ks are accessed through your employer. You can’t just go open up a 401K with any old bank or broker like you can with an IRA. It’s through your employer only.
Tax – Deferred: This means that when you put money into a 401K it comes out of your paycheck before taxes. This is fantastic because it means you don’t pay any taxes on money you invest up front. You will only pay income taxes on this money when you withdraw it during retirement.
Why You Should Care
The 401K is a huge benefit and unfortunately, a lot of people don’t understand just how huge it is.
Here are the 3 main benefits:
1. Lower Tax Bill Today
The first is that you can immediately lower your income tax bill this year.
Let’s get practical for a second.
Say you’re in the 25% tax bracket and you save $500 per month (or $6,000 per year) in a 401K. That means you immediately save 25% times $6,000 = $1,500 in taxes this year.
And we’ll see just how huge in a minute. Let’s look at the second benefit.
2. Your Investments Grow Tax-Free
It’s important to mention that second benefit which is that your investments continue to grow tax-free.
This means that every year when your investments grow, you don’t owe any taxes on what you made! If your 401K makes an extra $10,000 this year, you don’t have to pay any taxes on that money right now. You will only pay taxes later.
Because of this, your investments grow much more rapidly than they would if you were being taxed at normal rates.
3. You Get Free Money From Your Employer
The third major benefit is that most employers give a match up to a certain amount. It’s literally like they’re standing on the street corner giving you money, instead of asking for it.
If I was standing on the corner, willingly giving out free $100 bills to anyone who just reached out there hand, would you take one?
Of course, you would.
And you would think anyone who didn’t is an idiot.
That’s how most employers are. They’re literally giving out free money. You just need to reach out and take it.
Traditional 401K vs. Taxable Account Over Time
I know I keep going on and on about how great the tax benefits are. But let’s take a moment to really consider them.
If you were to use a regular investment account, you would have to pay income taxes and capital gains taxes on the money that you make every single year. You would also have to pay income taxes on all the money you invested.
As it turns out, over the years, these tax savings from your 401K end up being a pretty substantial amount.
Just take a look.
This chart assumes that you’re in the 25% tax bracket, investing $500 per month for 30 years, and receive a 7% APR on your investments.
At the end of 30 years, your 401K has $609,000 compared with the $462,000 in the regular account. That’s a tax savings of nearly $150,000!
Now let’s see what happens when we include an employer match of $2,000 per year.
This chart shows us just how much money we’re giving up on by not taking advantage of that hefty employer match. Just by adding it in, our balance jumps up another $200,000 to $813,000!
That’s $350,000 MORE than the regular taxable account without any employer match.
Now you can see the power of the 401K, and why you simply must take advantage of it.
Difference Between Traditional 401K and Roth 401K
Up to this point, I’ve been talking about the traditional 401K. But there is a special version called a Roth 401K that works a little differently.
Remember that a regular 401K lets you take a tax deduction. It lowers your total gross income for the year, which means you pay less in taxes NOW.
The Roth 401K is the opposite. Instead, you pay taxes now on everything you invest, but then your investment grows tax-free and you don’t have to pay any taxes when you withdraw the money.
Most corporate companies already offer a traditional 401K, and many are starting to offer the Roth 401K. So if the Roth is something you’re interested in, be sure to check with your HR department.
Are You Eligible to Participate?
For the most part, when you take a new job at a company that offers a 401K program you will be able to sign up almost immediately. But just be sure to check with your specific company because sometimes there are waiting periods, age limits, and hours worked requirements.
For example, the first company I worked for that offered a 401K required that you be 20 1/2 years old before participating. Since I started at 19, I had to wait a year and a half before I could sign up.
How Much You Can Contribute
Unfortunately, you cannot contribute as much as you want. The IRS does set a yearly limit. For 2016, you can contribute up to $18,000 to either a 401K or Roth 401K.
And if you’re over the age of 50, you can contribute an extra $6,000 for a total contribution of up to $24,000.
Employer Matching and Vesting
Remember that free money I talked about earlier?
Well, here it is. Not all, but most employers do offer some sort of matching incentive. For instance, the company I work for offers 50% matching up to 6% of my income.
This means that if I contribute 4% they will contribute 2%. Then if I do 6% they will do 3%. But if I contribute more than 6% they will stop at 3%, hence the “up to 6%”.
Every company is different so you will again need to check with your HR department about your specific rules. Just be sure that you contribute enough to the get the maximum amount from your employer.
If you worked for my company and make $60,000 a year, they give you a free 3% or $1,800. That’s free money you simply can’t afford to turn down. Not to mention, it grows tax-free! So don’t miss out on this.
In addition to your employer match, you also want to make sure you understand your specific rules for “vesting.”
Vesting is a fancy word that just means how much of the money in your account you get to keep if you get fired or quit your job. Now you always get to keep all of the money that you personally put in. But if you leave your job too soon, you may give up some of the money that your employer contributed.
Your vesting schedule might by 25% after 1 yr, 50% after 2 yrs, and 100% after 3 years. This means that if you leave your job after 1 year you only get to keep 25% of the money that your employer contributed. Likewise, after 3 years you get to keep all of the money your employer put in.
Again, just be sure to check with your HR department to find out what the specific rules are for you.
How and When You Can Actually Get The Money
Since this is a retirement account with special benefits, there are specific rules for when you can receive the money. For the 401K, you cannot start accessing the money until you are 59 1/2. Then at that time you will start paying income taxes on what you take out since you didn’t have to pay anything on the front end.
If you want to get the money before this you will have to pay a 10% penalty fee AND income taxes.
So it’s generally a stupid idea to withdraw money early.
For example, if you withdraw $20,000, and are in the 25% income tax bracket here’s what would happen.
First, you withdraw $20,000
Then you pay $5,000 in income taxes
Next, you pay a $2,000 early penalty
So you only get to keep $13,000 of the $20,000 you took out. That’s a 35% hit to your money out of the gate.
It’s like ordering a large pizza and then the delivery guy eating 3 slices before he gets to the door.
That’s why it’s dumb to withdraw early, so just don’t do it. This is money for retirement, and that’s it. Period.
*Now I should be honest and tell you that there are a few exceptions to the above rules, and you can check them out here for specific scenarios. But in general, this is retirement money and shouldn’t be touched until then.
Consider The Costs of 401Ks
You should know that most 401Ks do have a small administrative fee associated with them. In general, this is okay. Sometimes, especially if your employer doesn’t offer a match, it might make sense to not use the company 401K and use IRA’s instead. But normally, the admin fee is so small, that it’s still worth it.
In addition to the admin fee, you should also consider the fees associated with the individual mutual funds that you choose inside the 401K. I’ll talk more about how to choose these funds in a later post, but for now, check out these two articles on mutual funds and index funds.
Basically, most mutual funds have extremely high fees that eat into your returns. In order to combat this, you should choose low-cost index funds that often have fees that are 10 to 20 times lower than normal mutual funds.
What Happens If You Change Employers
The last thing I want to talk about is what happens when you finally do leave your employer. Whether you quit, retire, or get let go you eventually will have to figure out what you want to do with the old 401K.
And you’ve got a few different options.
- Roll over the old 401K to your new employer’s plan
- Roll over the old 401K into your own IRA (Individual Retirement Account)
- If allowed by your old company, you could leave the 401K with them (often for a fee)
- Withdraw your money in a lump sum cash payment
Like I said earlier, it’s basically never a good idea to withdraw your money. You’re going to get hit with a huge fee and be forced to pay income taxes.
It’s also normally a pretty bad idea to keep the 401K with your old employer. Normally you’ll get hit with a higher admin fee and there’s no good reason to keep it there (other than you just being lazy).
When it comes to rolling over your 401K to a new employer’s plan that can sometimes be OK. But often times your new 401K may not have very good investing options. The funds might be expensive, or they just might now have the types of funds you want.
For this reason, I generally recommend rolling over your 401K into an IRA that you manage on your own. IRAs are great because you have full control over the investments and you have plenty of options. You can guarantee access to whatever specific investment that you want.
What Are You Waiting For?
So that’s the gist of how 401Ks work. If you have more questions be sure to leave them in the comments below.
But I want to leave you with one final thought that my dad always told me.
Money doesn’t grow on trees.
Obviously, you know this, but it’s important to remember.
One day you’re going to want to retire or you’re going to be forced to retire and you’re going to need money. Unfortunately, most of us put off thinking about how important retirement saving is. And if you’re curious about how much you should be saving, be sure to check out this article here.
But the important thing is just to get started.
You know how 401Ks work now, you know the rules, you have no excuses. So walk into your HR’s office first thing tomorrow morning and get this taken care of.
Your future self will thank you.