Whether you’re a recent graduate new to the workforce or a seasoned professional, I imagine you’ve definitely heard a 401K mentioned at some point. We’ve all had those all-company, HR-driven meetings where someone from a financial institution comes in and makes you sit through a boring presentation with graphs showing stats that will affect you in 40 years. While you may have been thinking about your happy hour plans during these meetings, the truth is that those boring graphs are the key to your future financial freedom.
What is a 401K?
A 401K is the building block to your retirement independence. The IRS officially defines a 401K as “a qualified plan that includes a feature allowing an employee to elect to have the employer contribute a portion of the employee’s wages to an individual account under the plan.” In layman terms, your employer has set up an investment vehicle for you to contribute money to that you can use once you hit retirement.
401K Cheat Sheet:
- Only an employer can set up a 401K fund for employees to contribute to.
- Employer matching is like getting a 100% return on your investment. DON’T MISS OUT.
- It is recommended to invest 10-15% of your annual salary, but at a minimum always invest equal to your employer’s matching contribution limits.
- Some employers offer both Traditional and Roth 401K and in those cases consider investing in both.
- You can update your 401K contribution amounts at any time.
- A 401K provides tax implication benefits.
- The earliest you can withdraw funds without a penalty is 59 ½-years-old.
Why Do I Care about a 401K?
We are about to be in the midst of a Baby Boomer retirement crisis! According to research conducted by the Insured Retirement Institute (IRI) 45% of Baby Boomers have NO retirement savings and 28% of those that do have LESS than $100,000. Imagine how much you spend annually on housing, food, car payment, and other necessities. Even with Social Security ($1,461 per month average), could you make $100,000 support your supposed golden years? I know I couldn’t. So let’s learn from our elders and make sure that we are set up for a comfortable retirement.
401K At-A-Glance
These quick hits will be your cheat sheet to mastering your 401K strategy.
- Traditional vs. Roth
- Compounding Interest
- Employer matching
- Vesting
- Withdrawal Age
- Early Withdrawal Fees
- Tax Benefits
- Annual Limits
- Planning Is Key
Types of 401K – Traditional or Roth
There are two primary types of 401K investment funds, Traditional and Roth. The primary differentiator between the two is at what time you will pay taxes. In a Traditional 401K, you contribute pre-tax funds to the account and will pay taxes when you pull your investment out. In a Roth 401K, you will contribute post-tax funds to the account so that when you pull your investment out you won’t have to pay taxes again on the money you put in or on the growth.
The million-dollar question (literally) is which one is better. After reviewing an ungodly number of personal viewpoints and professional financial advisor articles, the clear theme is that the answer to this question is dependent on your personal financial situation. To find out which type is best for you as well as some other nuances to both types of 401K accounts, check out this lesson.
Compounding Is King!
Like all retirement investments, you will benefit from the power of compounding interest. This principle revolves around gaining interest on your previous growth plus principal investments. This will have a huge impact, allowing for enormous growth potential if you stay vigilant in your investments and give your retirement savings enough time to grow. This is another reason it is so important to start saving as early as possible.
Employer Matching – Instant 100% Returns
The saying “if it’s too good to be true, it probably is” is a mantra that has served me well throughout my life, helping avoid a myriad of consistently more sophisticated scams. When it comes to 401K matching, it truly is that good. Employer Matching is a benefit offered by employers where they will match a percentage of the investment you put into your 401K. This is to incentivize you to save for retirement, provide an additional employee benefit and is something that should be coveted when considering any job offer package.
It is challenging in any investment to get even a 10% return, but with employer matching, you are earning a 100% return on your investment instantly (up to the amount they match). That is a good deal in my book.
Often, employers will offer anywhere from 25-100% of what you invest up to a percentage of your annual salary. Now, this sounds more confusing than it is. The two examples below illustrate how this works.
Example 1:
- Employer Match: 100% up to 4% of your $50,000 annual salary
- If you invest 4% of your annual salary, you will have put in $2,000 into your 401K in one year.
- The maximum your employer would contribute is $2,000 per year, assuming you put in at least 4%.
- Your total end of year 401K contributions would be $4,000.
Example 2:
- Employer Match: 50% up to 8% of your $50,000 annual salary
- If you invest 8% of your annual salary, you will have put $4,000 into your 401K in one year.
- The maximum your employer would contribute is $2,000 per year (same as example 1), but this time you would have to invest 8% to get the same matching.
- Your total end of year 401K contributions would be $6,000.
Say 8% is too much and you can only put in 6% of your annual salary ($3,000). In example 2, you would then only be eligible for a match of $1,500, essentially leaving free money on the table.
Pro Tip: ALWAYS, ALWAYS, ALWAYS at least invest enough to maximize your employer’s match. This is free money that will be critical to setting you up for long-term retirement success.
Vesting
Often, employers will tie terms to their matching offers before those funds are owned by you. This is referred to as vesting. Some common types of vesting are:
- Immediate Vesting
- In this scenario, you immediately own all contributions within your 401K
- Cliff Vesting Schedule
- There will be no match or vesting for a period of time, then once you’ve reached that time of service, all contributions are 100% yours.
- Graded Vesting Schedule
- Employer’s contributions will become partially vested over a series of employment anniversaries, for example, four years. In this scenario, you may vest 25% of your matched funds annually over a four-year period. Once working at your company for four years, all of your current and future matchings are 100% vested and you own every previous and future penny contributed.
Withdrawal Age
As of 2020, you can pull out your retirement savings without penalty at 59 ½-years-old.
Since a 401K is deferred tax account, once you hit 72-years-old you are required to make annual required minimum distributions so the government can begin collecting on those sweet taxes. The IRS goes into detail on how to calculate these minimum required distributions, but we won’t bore you with that here.
Pro Tip: Always let your 401K reach maturity (59 ½ years). While there are cases where you desperately need to pull out money early, the early withdrawal penalty could massively undercut your ability to comfortably retire.
Early Withdrawal Penalties
A 401K is meant to be a retirement fund and due to the tax advantages it comes with, it’s not beneficial to dip into it until you hit the allotted withdrawal age. To enforce this, there is a 10% penalty applied to any funds pulled out of a 401K early plus the taxes owed.
There are scenarios in which you can pull out funds penalty-free due to certain hardships, but the hardship would need to meet IRS requirements. The short of it is if you can avoid it, always let your 401K reach maturity.
Tax Benefits
When contributing to a pre-tax 401K account, you are deferring a portion of your pay before taxes can be applied to that portion of your salary. Ultimately, this decreases your overall annual taxable income which could mean a higher refund or less owed to the government come tax season. This means you will pay fewer taxes now (although you will have to pay taxes when you take the investment out).
Annual Limits
There are annual limits to how much can be contributed to your 401K. While many of us couldn’t put aside enough investment to hit these annual limits early in our careers if we tried, it is good to know what could be invested as you grow in your career.
Note*: While it is rare for a company to contribute more than 10% of your annual salary towards a 401K, it is possible for them to contribute much more. That is why Combined Total Contributions exist, which consist of employee contributions and after-tax contributions from employer matches and personal investment.
2020 limits
| Age | Employee Contributions | Catch-Up Contribution | Combined Total Contributions* |
| Under 50 | $19,500 | – | $57,000 |
| 50 and over | $19,500 | $6,500 | $63,500 |
Planning Is Key
Now that you are a 401K expert, check out this calculator to input your own personal finances to determine what money you will need to contribute over your lifetime to best set you up for financial stability in retirement.
Check out additional topics to make personal finance SLIGHTLY EDUCATIONAL on our Personal Finance page.
