As popular as Michael Jackson, the 401k plan was basically created on the basis of saving for retirement.
Social security alone is not enough to fund your retirement. The average annual social security benefit in 2020 was $18036, which comes out to an average of $1503 per month. $1503 monthly income might not be bad for a low-income earner but, for people at the upper quartile, retiring at 66 with $18036 annually and $1506 a month in gross income in retirement is a no-no. So, the importance of directing a certain percentage of your monthly income to your 401k retirement account can never be over-emphasized.
“All days are not the same. Save for a rainy day, when you don’t work, savings will work for you”- M.K SONI
If you just landed a job that offers a 401k retirement plan, or you’re simply doing more studies about the plan, this guide will give a detailed and in-depth explanation of the aspects relating to the plan.
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Three facts about the 401(k) plan
- Ted Benna’s company, The Johnson’s Co., was the first company to provide a 401k plan to its workers.
- 401k plan was birthed in 1978 when Congress passed the Revenue Act of 1978 that includes the provision added to the internal revenue code-section 401(k). That Act enables employees to defer compensation without being taxed.
- In 2018, the total traditional assets 0f IRA in the united states was approximately 7.39 trillion US dollars.
What is a 401(k) plan and how does it work?
401k is all about saving for retirement. It is a tax-advantaged saving account or employer-sponsored retirement -plan that allows employees to save a portion of their income for retirement. A 401k plan gives employees the risk-free benefit of deferring compensation and also accommodates a process called “matching fund” where an employer makes a contribution on behalf of the employee.
It’s your responsibility to decide on the type of 401k you want, traditional or Roth, and the percentage of your income that you’re willing to give up for your 401k retirement. Keep in mind that the IRS regulates the amount you can deposit into your 401k account annually by setting limits. For 2020, the IRS raised the limit by $500. Employees aged 50 or under are allowed to contribute $19500, up from $19000 in 2019. Employees who are 50 and above are granted a catch-up contribution of $6500 up from $6000 in 2019, leaving the annual contribution limit at $26000.
Money in your 401k is deemed nontaxable by the IRS until it’s withdrawn or distributed. The percentage of your income deposited into your 401k account is not subject to federal and state taxes and that means you’re paying fewer income taxes because you’re only going to be taxed on the amount that is left after you’ve contributed to your 401k. Contributing to a 401k results in low-income taxes and this is one of the key benefits of the plan.
How do I pay fewer taxes contributing to 401(k)
Let’s work out the math. Ben is a single man who makes $60,000 a year. It’s estimated he will pay $8089.6 in federal income taxes this year. Note: the seven federal tax bracket for the 2020 tax year are 10%, 12%, 22%, 32%, 35%, and 37%. Your bracket depends on your taxable income and filing status.
But, instead of Ben paying $8989.6 in federal income taxes this year, he paid $7010.1 because he contributed 15% of his income to his 401k leaving his taxable income at $51000 instead of $6,000. Automatically, the $1979.5 he was supposed to pay on federal income taxes was deferred because he contributed $9000( 15% of his income ) to his 401k. To put it simply, Ben paid $1979.5 less in income taxes because he contributed 15% of his income to 401k.
Another important point: Ben’s paycheck didn’t go down by $9000 which is 15% of his income he signed up for. It went down by only $7020.5 Basically, he saved $1979.5 in lower taxes contributing to 401k.
“Deferred Compensation” means that the taxes on the income that were deferred will be paid on a later date. In the case of a 401k, these taxes will be paid after retirement when you take distributions from 401k. This means that the money in your traditional 401k account is subject to the current tax rate during distribution or withdrawal. If you have a designated Roth account, withdrawal is not subject to taxation.
What are the two types of 401k?
Basically, there are two types of 401(k) – Traditional and Roth. Although Traditional and Roth 401k operate on the same principle, the way they are tax clearly differs. Traditional 401k is a pre-tax investment account: the money you save in this account is not subject to tax until withdrawn (you pay tax on that money when you withdraw it in retirement). A Roth 401k is an after-tax investment account, you contribute with a post-tax income and then withdraw the money tax-free at retirement. For example, if Ben signed up for a Roth 401k, his paycheck will actually go down by $9000 instead of $7020.5.
Where does your 401k money go?
Money in your 401k account does not sleep, it works for you. Once you put money in your 401k account, you will be provided with a bunch of investment options ranging from stocks, bonds,exchange-traded funds(ETF), principle protection funds, capital preservation funds, stable investment funds, Guaranteed investment contracts(GICs), and even real estates.
Most often these investment options depend on your plan provider and the choices your plan sponsor(employer) subscribed to or make. The plan you choose( Traditional or Roth) and your investment portfolio are the two factors that determine the rate at which your savings will yield interest over your working years. For example, you will earn more investing in stocks and real estate than bonds but you equally stand at greater risk and volatility.
People who are far from retirement can afford to invest in more volatile or high-risk securities because they have time to recover if there’s a downturn in the market but people closer to retirement are advised to invest in low-risk securities like bonds.
So where does money in your 401k go? It goes into investments that yield interest over your working years.
401(k) matching fund/employee matching programs
“If your company matches your 401k contribution then, no matter what, contribute to your 401k first. You put in a dollar, they put in 50 cents. It’s an automatic 50 percent return on your money. You can’t pass that up. I’d rather have the 50 percent than pay 32 percent interest on credit cards” Suze Orman
What is an employer matching program? An Employer Matching Program is a collective contribution agreement between an employer and an employee where the employer matches a certain percentage of the employee’s contribution to a 401k. According to IRS, it’s not obligatory for a company to offer a contribution to their 401k plans – it’s optional.
How matching works
Let’s assume Ben’s employer offers a 100% match on all contributions, every year, on the first 6% of the employee’s annual income. Since Ben earned $60000, his employer will contribute a maximum amount of $3600 to his 401k each year. As a result of the aforementioned, Ben will see his 401k principal balance grow by $12600. What was actually deducted from his paycheck was $9000 – the extra $3600 is a bonus. A matching program is one of the key benefits of contributing to a 401k because it’s free money.
It’s also worthy to note that you should contribute the limit set by the employer to maximize benefit. For example, if Ben’s employer is offering 100% of employee contribution up to 6% of the annual income but Ben contributed less than 6%, let’s say 4%, his employer will contribute only $2400 instead of $3600 – automatically Ben has lost a $1200 bonus. You must meet the target set by the employer to reap the full benefit. On the other hand, if you contribute more than 6% set by the employer, the additional contribution remains unmatched. For example, Ben contributed $9000 but only received a $3600 bonus – $5400 is unmatched.
So if your employer offers a matching program, make sure you contribute enough to meet the limit – don’t leave free money on the table.
My employer doesn’t offer a 401(k). What should I do?
Companies are not obliged to offer a 401k retirement plan. The most obvious alternative to save for retirement is opening an individual retirement account( IRA). IRA’s are available in both traditional and Roth form and operate in a similar fashion to a 401k with a few differences. Traditional or Roth IRA’s differ from 401k in the following ways:
- IRAs offer more investment options.
- You are in control of your investment.
- The annual contribution limit is lower than a 401k.
- Contributions are deducted from a checking account instead of a paycheck.
- IRA’s are open by individuals using a broker or bank.
How does a 401k payout?
Once you’ve reached your full retirement age, which usually starts at 59½, you are eligible to start taking distributions or withdrawals from your 401k without facing any penalty like the 10% additional tax penalty set by IRS for early withdrawal. Generally, at retirement, different distribution options will be present to you. The common distribution options are:
- Withdraw the money in payment (periodic distribution)
- Withdraw all of it (lump-sum distribution)
- Roll the money into an IRA.
- Purchase an Annuity.
- Leave the account untouched to keep the tax-free growth uninterrupted. If you choose this option, you will be compelled to make a compulsory withdraw at the age of 70½ because mandatory annual distribution starts at this age.
In other words, Once you’ve reached your retirement age, you can choose to make a lump withdraw or receive the money in payments, or a combination of the two options without facing any penalty.
The pain of saving for retirement can never outweigh its benefit. If your company matches your 401k contribution, take advantage of it and contribute enough to meet the limit. Don’t leave free money on the table.
What if my company is among the approximately 22% that doesn’t match employee 401k contribution, should I still join the plan? why don’t I just open an IRA account instead?
Opening an IRA is not a bad idea, at least it comes with more investment options and a lower maintenance cost than a 401k. However, if your company doesn’t match 401k contribution, it’s still a good idea to join the plan because it allows a higher annual contribution. According to the American Association of Retired Persons (AARP), people are 15% more likely to save for retirement using 401k because contributions are automatically deducted from their paycheck.
No matter which you choose, it’s best to make sure you save for retirement using one of the two.