401(k)’s: Getting Started for the First Time?
Maybe it’s your first time having access to a 401(k), or maybe you are now playing catch-up (like me). Here, I hope to share the basics of a 401(k), and how to get started investing in one. No fretting necessary. This is something you absolutely can do. Sun’s up, guns up, folks! (Just kidding. I support reasonable gun ownership laws.)
401(k)’s: The Nitty Gritty
**All numbers/laws referenced are 2019 figures. Always check the most current tax year to see if things have changed.**
A Traditional 401(k) is a defined-contribution, tax-deferred retirement account. You usually have access to this through your employer, and the contributions are deducted through payroll.
Defined-contribution means the amount you put in is pre-determined. Your contribution is defined. When you set up (or edit your retirement account), you choose how much will be taken from your check each pay period (usually a percentage). This also implies, you can’t throw in lump sums into your retirement account when you have the extra money. It is a steady amount taken from your check, and moved to your retirement account.
However, you can edit your contributions at any time, though the changes may take a few pay periods to go into effect. The maximum you can contribute annually (as of 2019) is $19,000.
Tax-deferred means the amount you sock away in a 401(k) will not be taxed until you withdraw it (if you have a Traditional 401(k)—Roth 401(k)’s are taxed differently, which I will discuss later). You more than likely will not withdraw this amount until you retire. At that point, it will be taxed as regular income. (There are ways to withdraw these funds sooner, like a Roth Conversion Ladder, but that is not the scope of this article.)
Other Types of Retirement Funds
Other (mostly) employer-provided defined-contribution plans include 403(b) plans for nonprofit institutions, 457 plans for governmental employers, IRAs, and 401(a) plans. What you have access to, depends on your employer.
A 403(b) and a 401(k) are treated the same in the eyes of law and the IRS. The $19,000 maximum contribution applies to both these accounts. If you happen to have both (maybe you work 2 jobs that each offer one of these plans), your total maximum contribution is the combined dollar amount of both of these plans. When I refer to 401(k)’s in this article, just about everything I say will also be applicable to 403(b) accounts.
A 457 account has a maximum contribution limit of $19,000. You can contribute to this independent of your 401(k). If your employer offers you both, and you are able to max out both for a total of $38k, do it! Your future self will thank you with full-frontal hugs. Or a polite handshake. Whichever you prefer.
An IRA is a separate account, that you have control over. It is not through your employer, and the maximum contribution for 2019 is $6,000. You can set this up, through the bank of your choice, and contribute to this on your own. If you do not have access to a retirement account through your employer, definitely look into setting up an IRA. This is not technically a defined-contribution plan, as you can add money whenever you like, but I wanted to include it anyway.
A 401(a) account has a few more nuances that I am choosing to not go into today (mainly because I want to stick to 401(k)’s). However, here is a fantastically simple breakdown by The Finance Buff.
Traditional 401(k)’s vs. Roth 401(k)’s
Back to 401(k)’s. There are two variations of 401(k)’s: Traditional and Roth. The difference lies in how they are taxed.
Traditional 401(k)’s are tax-deferred immediately. When you get paid, your retirement contribution is taken off the top of your paycheck, out of your gross pay. It is moved to your retirement account where it stays and grows (depending on what investment options you choose).
You can begin withdrawing from this account at age 59 1/2. If you withdraw earlier, you will pay regular tax on the withdrawal, and a 10% penalty.
You will pay taxes (on both your contributions and your earnings/growth) as you withdraw the money. The advantage to a Traditional 401(k) lies here. It reduces your tax burden immediately.
This can be beneficial, especially if you are in a higher tax bracket now. Since your contribution isn’t included in your Adjusted Gross Income (AGI), your income reported to the IRS is less, thereby reducing the amount taxed in the year you earned the income.
Roth 401(k)’s are not tax-deferred immediately. Instead, when you receive your paycheck, you are taxed on the entire amount earned, and then your retirement contribution is moved to your Roth 401(k). There it stays, to grow just as a Traditional 401(k) does, never to be taxed again. This means when you withdraw later in life, you do not pay taxes on the withdrawals.
You can withdraw any amount you contributed to this account before 59 1/2 penalty-free (you cannot withdraw the growth without penalty).
The advantage here is, the growth your account has seen over time (through interest, price appreciation, and dividends) is never taxed. While you have to pay taxes immediately, you have the advantage of not paying taxes on alllll that beautiful growth afterward.
Why You Should be Using Your 401(k)
Now why would I (or you) want to take home less money, and instead put it in an account I can’t touch until age 59 1/2? Well. I’m so glad I asked.
- My Future: I care about me! No matter how much I love my job, I don’t want to have to work forever. Not to mention, I have no idea what the future holds. As healthy as I am now, I may not be later in life, which may make it harder to work as I am now. Financial security for the future is paramount.
- Lowers My Tax Burden: Whether I pay the taxes later in life (Traditional 401(k)) or up-front (Roth 401(k)) I win. Why?
- Traditional 401(k): I reduce the amount of taxes I pay now. Say I am in the 24% tax bracket while filing as single, and I earned $125,000. My tax burden after the standard deduction ($12,000), would roughly be $21,409. Instead, if I contributed the maximum amount allowed ($19,000) to my Traditional 401(k), it would be deducted from my income. My tax due would amount to roughly $16,849. That is a difference of $4,560!
- Roth 401(k): I reduce the amount of taxes I pay later. Yes, I’d have to pay taxes now, but the growth wouldn’t be taxed. Im 32 years old now, and if I contributed the same $19,000, I’d pay taxes on it now. By 59 1/2 I would’ve earned $118,063.48 in growth (annualized at 7%) all of which wouldn’t be taxed. The tax advantage with a Roth is, the growth isn’t taxed. And as you can see, the growth can be tremendous.
- Reduces Lifestyle Inflation: Contributing the full $19,000 isn’t always possible, depending on income. However, as my career progressed, and as I earned more, the pay bumps allowed for me to bump my retirement contributions up. First by 1%, then 5%, then 8, then 10. Finally, I went all in used the calculated percentage of my income equaling 19,000. Rather than blasting my raises at a new car note, or restaurants, or chic clothes, I’ve bumped my retirement contributions up. This way, I don’t allow for lifestyle inflation to creep in. Lifestyle Inflation: increasing my spending because my income has increased.
- Employer Match: Some employers will “match” your contributions. A previous employer of mine would match every 1% of my contributions up to 4%, and then match .5% for every 1% after up to 5%. This means if I contributed 6%, they would contribute 5%. That’s free money your employer is giving you! It’s yours! If you are starting out, I strongly suggest you contribute at least up to the amount that will give you the full employer contribution.
- Psychology: It is more difficult to manually transfer money out of my checking to my savings account, than it is to have it taken out of my check before I see it. Take the second-guessing out of savings: use your retirement accounts. Socking money away in savings is fantastic, and definitely a priority, but your savings account isn’t going to pay you the same interest as your retirement accounts. The compound interest and growth in retirement accounts vs. a savings account can’t be beat. (Another option would be to put money in taxable brokerage accounts. This is awesome, and will more than likely generate nearly similar returns as a 401(k). However, you will lose the tax advantages the 401(k) holds.)
- There are two types of 401(k)’s: Traditional and Roth. Each have different tax benefits. The tax benefits are fantastic.
- The maximum contribution annually to either accounts (or both) is a combined $19,000.
- You cannot start drawing on your 401(k) accounts penalty-free until age 59 1/2 (with the exception of Roth accounts. Here you can only withdraw your contributions before 59 1/2—not the growth).
- There are other retirement vehicles you can use (401(a), 457, and IRAs) in conjunction with your 401(k). Each vehicle have their own rules.
- You earn waaay more money over time investing the money in a 401(k) than if you put it into a savings account.
- You can only defer money you’ve earned into 401(k) accounts. This is usually done through your employer’s payroll.
- Always take at least up to the employer’s match when contributing to retirement accounts.
Did I miss anything? Still confused? Shoot me a comment and I will be happy to respond!