I’m sure that at some point in your adult life (or even earlier for the lot of us) you’ve heard that its important to save for retirement. Tax advantaged retirement accounts are one of the best ways to go. The most common one is a 401(k). In this blog post, we’ll cover 401(k) basics, including what it is, how it works, its benefits, and some tips for maximizing your retirement savings.

Understanding 401(k) Basics

When it comes to planning for retirement, a 401(k) is one of the most popular and effective tools available, especially for those in the corporate world. Investing in and understanding how a 401(k) works can get you to a comfortable retirement.

What is a 401(k)?

A 401(k) is a retirement savings plan sponsored by an employer. It allows employees to save and invest a portion of their paycheck before taxes are taken out. That means you’re using pre-tax money to fund this account.

This retirement account is named after the section of the Internal Revenue Code that created this kind of account. Ted Benna, the consultant who “invented” the 401(k) was the first to realize and invent the 401(k) from the IRS Code. He had a tough time getting companies to adopt it at first. Now they’re standard.

How Does a 401(k) Work?

Contributions

When you start working in the US, at orientation you may get some paperwork regarding a 401(k) retirement plan. When you send money to your 401(k) account, it’s called a “contribution.” Contributions to your 401(k) are an excellent way to save for retirement for two main reasons:

1. It reduces your taxable income or your “Adjusted Gross Income” so you’ll pay less in income taxes.
2. Investing pre-tax money will accelerate your ability to compound your retirement savings. This is huge, and a big reason we’ve become millionaires. You’ll be able to invest more pre-tax than you would post tax because of the tax savings.

For whom and limits

There are two main kinds of 401(k)s, the pre-tax, traditional version and the post-tax Roth 401(k) version. For this post, we’ll focus on these accounts. But there are two other different kinds of 401(k)s. SIMPLE & Solo. Below is a brief overview for who qualifies and contribution limits for 2024:

• For small companies with less than 100 employees, they may offer a SIMPLE 401(k) where the max contribution is $16,000 and catch-up contributions are $3,500 for employees 50 or older. Employers are required to make a matching contribution of a max of 3% of an employee’s salary or a minimum of 2% of each participating employee’s wages.
• For the self-employed they can open up a solo 401(k). The contribution limit is $23,000 and a $7,500 catch-up for those 50 and older. There’s an allowance for the “employer” to match up to 25% of the employee’s AGI or a combined employee/employer contribution of $69,000, whichever is lower.
• The most common 401(k) is the sponsored plan by larger companies/organizations. The max an individual can contribute to a traditional or Roth 401(k) is $23,000. There’s a $7,500 catch up for those 50 and older. Employees can contribute to either or both 401(k) account types. Employee and employer contributions cannot exceed $69,000. Plus, there are other contribution limits for highly paid workers.

Roth 401(k)s

Some employers also offer a Roth 401(k) option, where contributions are made with after-tax dollars, and withdrawals in retirement are tax-free. Roth 401(k)s are very similar to Roth IRAs, but with these key differences:

• In 2024 Roth 401(k)s have a contribution limit of $23,000. Roth IRAs have a $7,000 contribution limit.
• Roth 401(k)s are employer sponsored. You only have access to a 401(k) if your employer offers it. Roth IRAs are opened up by an individual.
• You can contribute up to the max for a Roth IRA and 401(k) Roth. Contributing to one doesn’t reduce how much you can contribute to the other.
• In 2024 catch up contributions for a Roth IRA for those 50 or older are $1,000 and $7,500 for 401(k)s.

Is a Roth 401(k) right for you?

A 401(k) Roth is a good option for folks who are just starting out in their careers and have a long time horizon. This is because there’s a trade-off; taxes are paid upfront, not when you withdraw the money. You’re making a bet when you choose a 401(k) Roth over a traditional that you’ll be in a higher tax bracket when you retire.

I’ve gone back and forth on this. I’ve come to the conclusion that it’s probably better to go the traditional route and then invest the tax savings you experience into a Roth IRA. This way you can experience the benefits of both the traditional 401(k) and the Roth IRA.

The thought is, that since you’re in a lower tax bracket now, it’s better to take the tax hit early in life. By making contributions to a Roth 401(k) early you’ll have time to make up for the pre-tax benefit you’re missing out on. Keep in mind that retirees spend a lot less in retirement because their fixed costs are often lower. Retirees may have paid off homes, access to Medicare and senior tax exemptions. For example, when we ,the Moneyaires, retire our plan includes no longer having a mortgage on our home. We won’t be withdrawing the amount of money we used to make when we worked; we’ll be taking out enough to cover our expenses.

Opting Out Vs. Opting In

Part of the SECURE 2.0 act will require employers to automatically enroll employees into the employer sponsored 401(k) by 2025. Employees would then have to opt out if they did not want to participate. This is great news and many employers have already started automatically enrolling employees. I know most folks drag their feet when enrolling for retirement accounts, so this will help the ball moving. In most cases you should certainly contribute to your 401(k) to at least capture the “employer match.”

Employer Matching

Many employers offer a matching contribution to employees’ 401(k) plans. This means that for every dollar you contribute, your employer will contribute an additional amount, up to a certain percentage of your salary. Employer matching is essentially “free money” and can significantly boost your retirement savings. If you aren’t at least contributing enough into your 401(k) to get the full employer match, you’re leaving money on the table.

Now, I do have a caveat when investing in your 401(k). If the fees for your employer sponsored retirement account are very expensive you may only want to invest up until the match, if at all. WHAT?! Is Mrs. Moneyaire actually suggesting you not invest in your 401(k)?? I am – sometimes plans are so expensive and only offer investment sucking high fee funds (or worse still, annuities) as well as other administrative fees. If the fees are high enough, it may not be worth investing in. If you work at a place with plans that are high fee low growth, work with your employer to move to a servicer like Fidelity, Schwab or Vanguard.

Vesting

Though employers may also contribute to your 401(k), they may put some golden handcuffs on the contributions. It’s called “vesting.” Vesting refers to the amount of time you need to work for your employer before you have full ownership of the employer’s matching contributions. Your contributions are always 100% vested; however, employer contributions may vest over a period of years.

If you’re in a job that you hate and are worried about leaving because you’ll lose your vested shares, calculate out when a majority of your shares/employer contributions will vest and set that as your timeline to GTFO. Also, consider how quickly you’ll vest into future employer contributions somewhere else. Don’t make yourself sick and stick it out at a job because of vesting. Life is too short.

Investment Options

401(k) plans typically offer a range of investment options, including mutual funds, exchange traded funds, stocks, and bonds. This is where you need to be very cautious. There’ll probably be a long list of funds you can select from until you hit 100% of your investment selection. It can be very tempting to put a couple percent here and there in various funds and think that you’re doing a great job diversifying. That’s not diversification. Instead, I want you to review your options and put the bulk of your contributions in a fund that tracks the S&P 500 or the US Stock market for the cheapest expense ratio.

Next, find funds that track mid term bonds or the entire bond market in the US or globally and put money there, too. I also love REITs and if there are inexpensive REIT funds like VNQ available to you, drop some % there, too. You’ll want to be heavier into bonds and assets that throw off passive income as you get older.

You can skip the work and put your money into a single target date fund that will automatically invest you in the right mix of stocks and bonds. These funds are slightly more expensive (keep to a .20% expense ratio) but they take out the reallocation work for you at the end of the year. I really like this option as it simplifies the road to successfully investing.

For most working people, invest in a low cost, passively managed, indexed, broad based funds that track the S&P 500 or the total US stock market. I personally think “risk tolerance” is a vague and ominous sounding term that scares too many people out of investing in the wider stock market. If you invest too conservatively or make a decision to invest in a more expensive fund that promises limited downside (and also limits your upside) you’re going to do yourself a disservice in the long run.

Benefits of a 401(k)

Tax Advantages

One of the main benefits of a traditional 401(k) is its tax advantages. Contributions are made on a pre-tax basis, reducing your taxable income. Additionally, the money in your 401(k) grows tax-deferred, meaning you pay taxes on 401(k) withdrawals in retirement. Keep in mind that you could be in a lower tax bracket in retirement than when you were in your earning years. According to this Fidelity article, retirees will typically spend between 55 to 80% of what they did before retirement.

Employer Matching

As mentioned earlier, employer matching can significantly enhance your retirement savings. Taking full advantage of your employer’s match is one of the smartest financial moves you can make. You should at least contribute enough to earn the full employer match.

High Contribution Limits

401(k) plans have relatively high contribution limits compared to other retirement accounts. For 2024, the contribution limit is $23,000 for individuals under 50, with an additional catch-up contribution of $7,500 for those 50 and older.

When can you start withdrawing?

Did you know you can start withdrawing from your 401(k) penalty free (though not tax free) the year you turn 55? Yep. I’ll write an article about this so subscribe to the blog below if you’d like to learn more about this:

The standard answer is that you can start withdrawing from your 401(k) and most other retirement plans the year you turn 59 1/2. You’ll be required to start making required minimum distributions depending on when you turn 72:

• Before December 31, 2022: The year you turn 72
• After December 31, 2022: The year you turn 73
• After December 31, 2032: The year you turn 75

Loan and Hardship Withdrawal Options

While it’s generally best to leave your retirement savings untouched until retirement, 401(k) plans often allow for loans or hardship withdrawals in certain circumstances. This flexibility can provide a financial safety net in times of need.

You can also withdraw money from a 401(k) before retirement; however, you’ll have to pay a 10% penalty as well as ordinary income tax. Ouch.

Tips for Maximizing Your 401(k) Savings

1. Start Early: The sooner you start contributing to your 401(k), the more time your money has to grow through compound interest.
2. Contribute Enough to Get the Full Match: Always contribute at least enough to get the full employer match. It’s essentially free money and can significantly boost your savings.
3. Increase Contributions Gradually: Consider increasing your contribution percentage each year until you max out, especially when you receive raises or bonuses.
4. Diversify Your Investments: Spread your investments across different asset classes to reduce risk and increase the potential for growth.
5. Monitor and Adjust: Regularly review your investment choices and adjust them. If you were too conservative or too risky, you can always make a change and course correct.

That’s the 401(k) basics…

A 401(k) is a powerful tool for building retirement savings, offering tax advantages, employer matching, and flexible investment options. By understanding 401(k) basics and implementing smart strategies, you can set yourself up for a comfortable retirement. Start today, take advantage of your employer’s contributions, and watch your investments grow and compound over time.

Cheers!

Mrs. Moneyaire