[This post is part of my Back to Basics Post Series where I break down some of the most fundamental aspects of retirement planning. If you find this post helpful, check out the rest here, Back to Basics Post Series index.]
In this post I will summarize the pertinent information about 401(k) (“401k”) plans and some of the general strategies you should consider in order to ensure that you are making full use of the retirement tools at your disposal.
…the common name in the USA for the tax-qualified, defined-contribution pension account defined in subsection 401(k) of the Internal Revenue Taxation Code. Under the plan, retirement savings contributions are provided (and sometimes proportionately matched) by an employer, deducted from the employee’s paycheck before taxation (therefore tax-deferred until withdrawn during retirement), and limited to a maximum pre-tax annual contribution of $17,500 (as of 2013).
In plain English, a 401k plan is a retirement account that you can put money into where that money can grow in a tax advantaged manner. This makes it similar to an IRA. a 401k is funded from your income via payroll deductions from your paycheck. You control the size of the contributions, typically as a percentage of your income. Money that you put into a 401k is called a contribution. Money that you take out of a 401k is called a distribution. In 2013 you are limited to a maximum contribution $17,500 to a 401k. If you are over the age of 50, you are allowed to contribute an extra $5,500 (for a total of $23,000) as a “catch up” contribution. The defining difference between an IRA and a 401k is that 401k plans are employer sponsored. This means that your employer will control which brokerage manages the accounts in the plan and what types of assets you may hold in the account, among other things. An individual may not establish a 401k plan independently.
Types of 401k Plans
Like IRAs, 401k plans come in several flavors.
- A Traditional 401k is a 401k that is funded with pretax dollars. This means that you do not pay income tax on the money placed in the account. Since contributions to a 401k are made via payroll deductions, the contributions are never reported to the IRA as taxable income. This simplifies the process relative to a Traditional IRA, where you are required to claim a deduction for your contributions. No deductions are required for Traditional 401k contributions. When a qualified distribution is made from the a Traditional 401k during retirement, you are required to pay income tax.
- A Roth 401k is a 401k that is funded with post tax dollars. This means that you pay income tax on the money placed in the account. Just like a Roth IRA, since you’ve paid tax on the contributions you do not have to pay tax when you take distributions from the account.
The Good and the Bad of 401k Plans
There are several aspects 401k plans, both Roth and Traditional, that could make them advantageous when compared to IRAs but also several aspects that could make them less advantageous.
- 401k plans are tax advantaged. Any investment vehicle that allows an individual to legally avoid or defer paying tax is a good thing with respect to saving and building wealth.
- The assets available to you through your 401k plan are likely not exactly the same as the funds available to you as an individual investor. You should think of a 401k plan as an opportunity to purchase financial instruments with a group discount. Without going into too much detail about the financial structure of 401k plans, the contributions of all participants in the plan are pooled and then invested according to each employee’s direction. So, for example, if 10 employees all want to invest $1,000 into the same mutual fund, the plan will make one $10,000 purchase of that fund (basically). This means the plan has a large amount of buying power and, thus, typically has access to classes of funds with lower expense ratios and management fees. These less expensive variations are usually called “institutional shares” of the mutal fund and are not available to individual investors unless they have significant amounts of money to invest.
- 401k plan participants are usually able to avoid minimum initial investment (MII) requirements. An MII is the smallest investment amount a fund will accept to establish a new account. MIIs usually range anywhere from $1,000 to $10,000, or more. By avoiding the MII, 401k plan participants are allowed to invest as little as they want in the funds available.
- Perhaps the best aspect of 401k plans, some employers match their employees’ contributions. Free money! Many companies will consider this an additional benefit, like health insurance, and use it heavily while recruiting talent. There are many ways in which the match can be implemented, but most of the time the employer will match the employee contributions up to a certain amount relative to the employee’s annual salary. So, for example, an employer might “match 50% of the employee’s 401k plan contributions, up to a maximum of 4% of the employee’s gross annual wage.” This is just a complicated way of saying that the company will contribute 4% of your gross annual salary to your 401k account as long as you contribute a minimum of 8% of your gross annual salary. When considering job offers, I consider matching 401k plan contributions as additional salary.
- Most 401k plans limit the selection of mutual funds available. You may have as few as 5 funds to chose from. This is usually an attempt to keep the administrative and management costs for the plan down.
- Some 401k plans may be subject to onerous account management or administrative fees.
Which is Best, Roth or Traditional??
As with IRAs, most people ask me which type of account is best. This is a difficult question to answer because there isn’t a correct answer, each account has its advantages and the significance of those advantages will vary between investors. Generally this discussion can be summarized into two main ideas.
- Income Level – Since traditional IRAs allow one to pay less income tax now, it follows that the higher your income (and therefore the higher your effective tax rate) the larger the benefit one will realize by paying less income tax now. The general idea behind this is that most people will have a very small income in retirement (and therefore be subject to lower income tax rates). It’s optimal to pay tax on your IRA distributions then, instead of when you made the contributions and were exposed to the higher tax rates. As such, people subject to the higher marginal tax rates tend to favor Traditional IRAs while people in the lower marginal tax rates tend to favor Roth IRAs.
- Your Opinion on the Future of US Tax Law – This is the trickier of the two ideas and the one that is completely subjective. If you think that tax rates are likely to get lower in the future than they are today, it would make sense to contribute to a Traditional IRA. This will allow you to wait to pay taxes until retirement, when you think taxes in general will be lower. The inverse is also true. If you think that tax rates are likely to get higher than they are today, it would makes sense to contribute to a Roth IRA. This will allow you to pay those taxes now instead of in retirement when you think taxes in general will be higher.
I go into some more detail in my All About IRAs post and I encourage a look at the discussion about historical income tax rates in the US. I typically recommend the Roth option for younger people, particularly if they are subject to the lower marginal tax rates.
What Should I Invest In?
This is a complex discussion and one that is largely outside the scope of this article. Until I get around to putting together a more comprehensive discussion about asset allocation, I’ll point you in the direction of the three fund portfolio discussed on the Bogleheads website. This is a great way to diversify and index yourself to the global markets. When you learn more about investing and retirement planning you can come back and change your allocations. Another option I recommend is purchasing a Target Date Mutual Fund. Target date funds are attractive, particularly to new investors, because they are designed in such a way that the asset allocation within the fund will change (become more conservative) as the target date inches closer. This ensures an appropriate risk profile is maintained as the investor ages (and gets closer to retirement).
Optimizing Your 401k Contributions
In our discussion about IRAs we were less concerned with optimization. IRAs are simple, just contribute the maximum amount allowed, period. It doesn’t matter if you contribute it all in one lump sum, spread it out over 3 months, or spread it out over the entire year. As long as you get the money in there, you’re on the right path. In a way, a 401k plan in which you do not receive an employer match is very similar. Go ahead and contribute as much as you can. If you are fortunate to be able to contribute the maximum amount allowed by the IRS ($17,500 in 2013), your contributions will simply stop when you reach that point.
However, 401k plans in which there is an employer match can be a bit trickier. The optimization problem here is related to the employer contributions. You want to ensure that you get as much of those matching contributions as possible. Luckily this “problem” is easily solved with a little logic and some math to back it all up. All you need to do is follow two rules:
- Ensure that you are contributing at least the minimum amount required to capture the matching contribution. For example, if let us assume that your employer will match 50% of the your 401k plan contributions, up to a maximum of 4% of the your gross annual wage. You’ll need to make sure that you are contributing at least 8% of your salary to the 401k plan to capture then entire 4% offered by your company. If you were to only contribute 6%, the company will only match with a 3% contribution (50% of 6% is 3%).
- Ensure that you do not hit the maximum contribution limit until the very last pay period of the year. This will maximize the amount of employer contributions. Once you hit your annual contribution limit, your 401k plan administrator will stop your payroll deductions and you’ll stop receiving those matching contributions. Perhaps an example will help. Let’s assume, for the ease of calculation, that my friend Tim makes $100,00 a year and look at the following two scenarios,
- Option 1: Since his salary is so high, Tim can afford to contribute 25% of his gross salary to his 401k plan. If he gets paid twice a month, his paycheck will be . Of that, 25% will be deducted and contributed to his 401k account, as well as a matching 6% contribution from his company, . At this rate, it will take Tim 17 paychecks to reach the maximum annual 401k contribution limit. He will have contributed $17,500 and received in matching contributions from his company. The total contributions to Tim’s 401k account in Option 1 is $21,750.
- Option 2: Tim makes sure that he contributes exactly the maximum allowed annual contribution. Since he makes $100,000, this would be 17.5% of his gross salary. Therefore, with each paycheck, 17.5% will be deducted and contributed to his 401k account, as well as as well as a matching 6% contribution from his company, . At this rate, it will take Tim exactly 24 paychecks to reach the maximum annual 401k contribution limit. He will have contributed $17,500 and received in matching contributions from his company. The total contribution to Tim’s 401k account in Option 2 is $23,500.
As this example shows, Tim gets a significantly larger contribution, almost 40% more, from his company when he makes sure to spread out his contributions evenly over the course of the entire calendar year. It costs him nothing to do so and he ends up contributing the same amount, $17,500, regardless By spreading his contributions out he ensured that he would receive an employers match at each paycheck and the maximum possible match over the course of the year. Personal financial optimization at it’s finest.
- What counts towards the annual contribution limit? My contributions, or my contributions and my employer’s matching contributions.
- Only your contributions count towards the contribution limit. This means that you can actually have more than the annual limit contributed to your 401k account each year if your employer matches a portion of your contributions. See the example I did above.
- I have been contributing to a 401k at work but I am changing jobs soon. What is going to happen to my account?
- You have a few options with 401k accounts from old employers. You are allowed to keep your money in the plan where it is right now. You will no longer be able to contribute to that account, but you can keep it there for as long as you like. Your other options related to “rolling over” the account into a new account type, generally you can roll it over into a Roth IRA or into your new employer’s 401k plan. Talk to you new plan administrator or the brokerage at which your 401k account is held about these options.
- I only have access to really bad funds in my 401k, should I still contribute to my 401k?
- If you get any sort of employer match, I think that YES you should still contribute. The amount of “free money” that you are receiving via the employer contributions probably greatly exceeds the amount of money you would be paying in management fees. However, if you do not receive an employer match, I think that you would be better off contributing to an IRA instead of a 401k plan with high fees.
- My employer doesn’t match contributions, would I still contribute to my 401k?
- In this case I would recommend first contributing to a Traditional or Roth IRA first. Then when you max out your IRA, start throwing money into the 401k.
- Can I change what funds I hold in the 401k at a later date.
- Yes, absolutely.
I hope that this article was helpful without being too simple. It can be difficult to explain material like this to such a diverse audience. If you have any questions, please don’t hesitate to leave a comment or send me an email. I’ll help however I can. And if you found this article helpful, please let me know that too! And don’t forget to take a look at the rest of my Back to Basics Post Series.