401k Plans: Basics For The Employee

November 29, 2018

Planning & Saving

401k Plan Benefits

A 401k plan is a popular type of retirement savings account managed by a company. Because most people can’t or don’t want to work forever, they need to gather a pot of money to generate income which will replace their salaries upon retirement. Decades ago, it was common for larger companies to offer lifetime pension salaries to retired employees, but today this is rare for non-union workers. The 401k plan is meant as a replacement for the traditional pension plan. Instead of guaranteeing retirees a lifetime salary, the company puts a certain amount of money into an investment account every year of service. Usually, this largesse is in the form of a matching contribution; that is the employee must first “contribute” some of his salary into his 401k investment account, which the company then matches. Assuming the employee keeps saving and the investments do well, the employee retires with a nice pot of money to spend on his “golden years”.

Government Benefits

In addition to possible employer matches, the government offers substantial tax discounts on 401k plans. (The “401k” of the plan refers to the relevant section of the tax code.) Employees withholding are sent to a typical 401k plan pre-tax and investments grow tax-deferred as well. While the taxes will ultimately be owed when money is taken out of the account, this will be decades in the future. Delaying the payment of taxes is like having an interest-free loan from the IRS, which in the meantime can be invested and compounded. This tax treatment adds a significant boost to the earning potential of retirement accounts. If the matured investments are later rolled into an Individual Retirement Account (IRA), they can be contributed to a charity during retirement tax-free, which is a tremendous bargain. The matching contributions and tax deferral of 401k plans are valuable benefits which you should try to take advantage of.

Building a Million Dollar Nest-Egg

For a simplified example, say that you want to accumulate $1,000,000 for the future. During 35 working years, you save and invest 3% of your $100,000 annual salary at 8%. Due to taxes on the amount savings and investment earnings, this $105,000 (35 x $3,000) would grow to roughly $230,000, well short of your goal. A company’s 401k match doubles the amount invested, and it now accumulates to $460,000; much better, but still, a fraction of the million you’re is aiming to gather. It is only by combining, both the company match and the 401k’s tax deferral, that you can retire with an account worth $1,033,000, which is pretty incredible considering all you had to forgo yearly was $3,000 (pre-tax)! While the money will be taxable as it’s withdrawn, retirees are often in a relatively low tax bracket, and the taxes can be mitigated along the way with various other strategies. A well-run 401k plan is a crucial component of an employee’s financial well-being.

Of Course, There’s a Catch

So what’s the catch? Unfortunately, there are several, and employees need to review the (boring) plan paperwork before they sign up. Some companies, even those with a 401k plan, do not offer any matching contributions. Those that do often make them dependent on a certain amount of years of service, so if you leave too soon, you forfeit some or all of the match. This caveat needs to be checked out under the “vesting schedule” in the 401k’s summary document. More importantly, once the funds are placed into a 401k account, they can’t be taken out until retirement (59.5 years usually), or leaving the company, except under specific conditions such as for certain medical or higher education expenses. Also, any funds withdrawn before retirement age is assessed a 10% penalty tax by the IRS on top of ordinary taxes. While you can often borrow against part of the value of the 401k account (and pay interest back to yourself!), these limitations do mean that what you put into a 401k plan, expect to leave for the long haul.

The final challenge is that in most 401k plans, investing the money is at the employee’s direction. In essence, companies shifted the responsibility for growing money for retirement onto the employees. Usually, each 401k plan offers a bunch of investment options, like mutual funds, but it is up to the employee to sift through them and decide which to select. Hopefully, they choose well, and the investments grow as planned. But realistically, most employees struggle to choose a properly diversified portfolio. To make sure you don’t blow the opportunities offered by a 401k plan, you should seek the help of a knowledgeable friend or read up on some investment basics. Like all good things in life, building a retirement nest egg takes some work.