If you’ve even thought for a minute about saving for retirement, chances are you’re familiar with the 401(k) savings plan. You may know that, for example, a 401(k) is a type of “defined contribution plan,” and you may know that it receives special tax treatment from the IRS. You may also remember some of the rules regarding early withdrawals and roll-overs – or maybe not.
For anyone who is building a retirement strategy that features a 401(k), it’s important to have a deep understanding of both its advantages and disadvantages. In what cases is it most useful? Are there hidden costs? And, most importantly, how does the dang thing work? However, before we try to answer that question, let’s make sure we understand the basics.
What is a defined contribution plan?
A defined contribution plan is any retirement plan to which an employee or employer regularly contributes a certain amount. Often, the employee chooses to send a fixed percentage of monthly income into the account, and this contribution is automatically withdrawn directly from his paycheck – no effort required. The money that doesn’t go into the employee’s take-home pay slowly accumulates, the balance earns interest from investments, and by the time of retirement, it grows into a substantial retirement structure. That’s the idea.
In a defined contribution plan (unlike a defined benefit plan), there is no guarantee of the income you will receive in retirement. That doesn’t mean such plans can’t be just as effective, though, and employers often sweeten the deal by contributing directly to your account.
Why Employers Offer 401(k)s
In 1978, when the law authorizing the creation of the 401(k) was passed, employers typically attracted and retained talent by offering a secure retirement through a pension (a type of defined benefit plan). The 401(k) created a whole new system, with more flexibility for both employer and employee. One way it did this was by giving employers the option to “match” employee contributions.
Matching is a very transparent process: for every dollar you put into your 401(k), your employer also puts in a dollar up to a certain amount or percentage of your income. There is no secret here. If your employer promises to match all 401(k) contributions up to 5% of your income, and you contribute that amount each month (5% of your income), your employer will match you dollar for dollar each month. It’s a win-win situation. You’re doubling your money, and your employer is creating happier employees.
A common example of such a matching agreement is for the employer to match 100% of all contributions up to 6% of the employee’s income. If you earn $100,000 a year, your employer will match up to $6,000 in annual contributions. So if you contribute $6,000 to your 401(k) over the course of a year, your employer will match the $6,000 and you’ll get a total of $12,000.
Note that you can still contribute more than 6%, but your employer will not match those extra dollars. So, if you contribute $10,000 during the year, your employer will only match the first $6,000. Still – that’s 6,000 extra dollars in your account. Nothing to sneeze at. A 401(k) calculator can help you see how these matching contributions or larger annual contributions can affect your retirement savings.
Other benefits of a 401(k).
Even for employers that do not offer any matching programs, every employer with a 401(k) plan is responsible for administering the plan. It may not seem like a big deal, but it really saves some trouble for employees. As an employee in a 401(k) plan, you don’t have to worry about complicated rules and regulations you need to follow or managing the funds you invest your money in—your employer takes care of everything. From it to you. It is very little preserved paper.
At the same time, employees who participate in a 401(k) retain control over their finances. While employers provide a list of potential investment choices, usually a variety of mutual funds, employees have some freedom to determine their own strategies. Whether you’re willing to take a little more risk with your investments, or if you want to play it safe, there’s probably an option for you.
401(k)s and your taxes
Ah yes. Perhaps the biggest advantage of a 401(k) is that contributions to a 401(k) savings account are made pre-tax. When your employer sends a paycheck, 6% of your income (for example) that you decide to contribute to your 401(k) has already been withdrawn, before your employer withholds anything for taxes. This results in 6% less income being taxed and lower overall tax bill.
By comparison, think about what happens when you put money into a bank account: Your employer sends you a paycheck, but deducts about 30% of it to give to the IRS to withhold taxes. So for every dollar of pre-tax income, you can put just 70 cents into your savings account. That’s a big difference!
Of course, keep in mind that the income sent to your 401(k) is not tax-free. Ultimately, you will pay income tax on it, but only when you withdraw it. If you don’t plan to do so for 10, 20 or 30 years, that extra 30 cents is a long time to earn interest. He adds.
So let’s use a 401(k) calculator to show you how. For example, let’s say you are 40 years old, and plan to retire at age 67. That leaves 27 years for your current investments to realize value. Using the previous example, in which you earn $100,000 per year, and your employer matches up to 6% of your income, you could earn more than $10,000 this year by putting your $6,000 into your 401(k) as opposed to standard savings. account—if you assume both will earn the same 4% rate of return.
Of course, a large part of that difference is a result of your employer’s matching funds. That extra $6,000 basically makes the calculation a no-brainer. Even without matching, a 401(k) can still make financial sense because of its tax benefits. Let’s go back to the 401(k) calculator to look at the same example—you earn $100,000 and contribute $6,000 a year to your savings—but without any employer matching. Even in this case, you’ll save an additional $2,000 just by using the 401(k).
Disadvantages of 401(k).
A 401(k) really only makes sense as a retirement savings plan, not as a regular savings account. There’s a 10% penalty for withdrawals before your 60th birthday (well, before you turn 59.5 but how many people celebrate that milestone), and that’s on top of the regular income tax you pay. That penalty is enough to negate the other financial benefits of a 401(k), so whatever money you want to have ready access to should be saved elsewhere.
Second, investments made through a 401(k) often carry risk. As mentioned above, you’ll be choosing from a range of investment options with varying levels of risk, and with many of these, it’s possible (though unlikely) that you could lose money over time. Keep that in mind when deciding how to allocate your retirement savings. It’s also important to stay away from 401(k) plans that charge high fees if you want to make more of your money work for you.
However, overall, a 401(k) is the best retirement savings option for you. Given the tax benefits, ease of use, and the possibility of those additional matching funds, if your employer offers a 401(k), you should definitely consider taking advantage of it. Try putting your exact numbers into a 401(k) calculator to see how it might work for you.