You’ve heard of 401(k)s at work, and heck you might (hopefully!) contribute to one. But do you really know how they work and how they can maximize your retirement savings? Let’s dive in and learn more about the Traditional 401(k) account.
IN THIS WEEK’S EPISODE
- Understanding the basics of a Traditional 401(k) account
- How do contributions work for a Traditional 401(k)?
- Breaking down the ins-and-outs of how a Traditional 401(k) works in retirement
- How you can track management fees for your retirement accounts with Personal Capital
- An example scenario of how a Traditional 401(k) beats investing in a taxable account
- Explore the limitations of a Traditional 401(k)
- Why management fees are the silent killers of retirement accounts
Understanding Retirement Accounts: Traditional 401(k)
Before we dive into the Traditional 401(k), let’s set the table first.
There are four primary types of “defined contribution plans,” or plans offered through an employer:
- 401(k)s are the version that corporations offer to their employees.
- 403(b)s are for employees of public education entities and most other nonprofit organizations.
- 457s are for state and municipal employees, as well as employees of qualified nonprofits.
- Thrift Savings Plans (TSPs) are for federal employees.
I’m not as familiar with 403(b)s, 457s and Thrift Savings Plans, and we’re not going to cover those here, so if you have experience contributing or withdrawing from these accounts, I’d love to hear from you on your experience.
There is also another type of retirement account, the IRA, which stands for Individual Retirement Account. As the name implies, it’s a retirement account for individuals. It was created as an alternative to those who didn’t otherwise have access to a defined contribution plan at work. This would allow a small business owner or entrepreneur who didn’t set up a formal 401(k) to still contribute to their retirement. It might also be used as a supplemental retirement vehicle for those who also contribute to a 401(k). We’ll cover IRAs in a different episode.
Then there are 401(k)s, which are what most people are familiar with and what we’re going to focus on today. They are retirement savings accounts that are set up and managed by your employer, or more accurately through a custodian that they assign to manage the account. This could be through Wells Fargo or a local investment advisor. They’re the one helping manage your retirement savings and those of your co-workers.
Within 401(k)s, 403(b)s and IRAs, there are two types of each: traditional or Roth, with key differences between the two types being when you pay taxes on the money. With a traditional account, you don’t pay income taxes on the contributions you make during your working years and pay income taxes in retirement on whatever you withdraw from your retirement account each year. A Roth account is the inverse; your contributions are all made with post-tax dollars, which means that you’re able to contribute less than a traditional account but in your retirement all of your gains are tax-free. Sometimes you have a choice, sometimes you only have one option, but it’s always important to know the differences between the different types of accounts so you can make an informed decision when you have a choice, depending on your situation.
The Skinny on the Traditional 401(k)
The 401(k) as we know it was almost accidentally created. The Revenue Act of 1978 was an answer by Congress to the pressures they were under from high-worth individuals that were looking for a tax shelter for their money. A guy named Ted Benna came across an obscure section of the Revenue Act, titled Section 401(k) (I can’t imagine how exhilarating the first 400 sections of the Revenue Act were…). He brought the idea forward to his employer as a benefit they could offer to employees, and from there, the employer-sponsored 401(k) was born.
Over the years, the IRS and Congress put rules and protections in place to solidify employee contributions to their 401(k) via pre-tax payroll deductions.
401(k)s gained in popularity at a time when companies were looking to get out of burdensome pension plans, and this provided them with a tax advantaged benefit they could offer employees in lieu of a pension. It’s not a direct correlation, but it’s certainly more than coincidence.
There we have it. 401(k)s are still a relatively new concept. If you were 28 years old and working at Johnson & Johnson back in 1980 when Ted Benna championed the 401(k), and you started contributing on Day 1 to your 401(k), only this year would you be turning 65. 401(k)s have only recently started seeing their first withdrawals from employees who have contributed to their 401(k) for their full career.
How a Traditional 401(k) Works
With a traditional 401(k) account, your money is taken out on a pre-tax basis, directly from your paycheck (out of sight, out of mind, right?). Specifically, it’s deducted from your paycheck after you pay social security and medicare taxes on your income, but BEFORE your income tax is withheld. The order of operations matters here, because if you’re contributing 8% of your salary to your 401(k), it’s more accurately 8% of 92.5% of your salary, because you pay 7.5% in FICA taxes.
Because the funds are taken out pre-tax, you’re working with a higher number that you’re able to contribute to your 401(k). You don’t have to pay income taxes on that money, which if you’re in the 25% tax bracket, your contribution is essentially 25% larger than it would be through any other investment that you’d make using your net income.
As a result, over the length of your career, your retirement savings is able to grow at a significantly faster pace.
What’s more, employers will sometimes offer some sort of a matching contribution into your 401(k), which can accelerate your retirement savings even quicker. Every employer match plan is different, and they’re definitely not all the same, so before you get jazzed about your employer offering a match, make sure you understand how the match works, especially when there are a lot of percentages floating around. For instance, they might match 100% of your contributions up to 3% of your salary and then 50% of the next 2% of your contributions. In this scenario, you’d need to contribute to 5% to get the max match from your employer. They would match the first 3% and half of the next 2%, which is an additional 1%, so if you contribute 5%, you’d get another 4% from your employer. The other tricky terminology you need to be aware of is the vesting of the matching contributions. Your contributions will always be 100% vested, which means that you’ll always “own” your contributions and can take them with you if you leave your job. Employer matches are often on a vesting schedule, which means that for every year you stay at your employer, you gradually move up the vesting schedule. In other words, if it’s a four-year vesting schedule, your employer match will vest an additional 25% per year. So, if you leave your employer after 2 years, you’d be 50% vested, and be allowed to keep 50% of whatever your employer has contributed to your 401(k) on your behalf.
When you make your contributions, the administrator of the plan directs your contributions to one of the funds that they have available. You make these decisions when you first enroll in the plan, and you’re usually able to login to some sort of online portal to change your fund selection if you’d like. The average 401(k) has 19 funds to choose from, so this can often be a bit daunting for average folks. To address this, many 401(k) plans offer Target Date funds, which define a target retirement date, say 2045, and then it gradually adjusts the asset allocation mix between stocks and bonds. The closer you get to that target date, the heavier your portfolio will be weighted toward bonds, since you’re likely looking to minimize investment risk that you find in stocks.
If you leave your employer and you have vested contributions (yours and possibly some of your employer’s), you can leave them in the 401(k) plan, you just can’t contribute to the plan anymore. What most folks do is to roll those funds over into an IRA that you can self-manage, which can give you greater flexibility into different funds and asset allocation mixes than you could get in your 401(k) plan at work.
When you’re ready to start withdrawing from your 401(k) for retirement, You can begin withdrawing funds from your 401(k) when you’re 59.5 years old without penalty. There is a special provision that if you’re over 55, but not yet 59.5, and you leave you employer after age 55, you can begin withdrawing funds from the 401(k) early. If you roll those funds over to an IRA after leaving your employer, the provision is no longer an option and you need to wait until you get to 59.5 to withdraw those funds, so as you get closer toward standard retirement age, it’ll be important to monitor your account and your options.
Another beneficial feature of a 401(k) is that it’s a protected asset, which means that it is protected from creditors. Keep this in mind before you think about using your 401(k) funds to fend off foreclosure, pay off debt or start a business. If you would file bankruptcy or go into foreclosure, creditors can’t come after your 401(k) money.
What Happens in Retirement
Because you contributed to your 401(k) tax-free throughout your career, you’ll accumulate a happy little nest egg. But it also means that in retirement it’s time to pay the piper. You’ll be taxed on whatever you withdraw from your traditional 401(k) at whatever your current income tax rate is in retirement. The Traditional 401(k) treats all money in the amount the same, so both your initial contributions and your gains will be taxed as the same. Note that if you have Roth 401(k), these taxes don’t apply. We’ll have a whole episode to Roth accounts, so we’ll set that aside for right now.
Let’s take a quick break and then come back to talk about an example scenario.
We’ll talk about fees a little later, but fees can really kill your retirement account’s mojo. The management fees are often hard to track and usually hidden deep in paperwork. One of my favorite tools to track management fees of our investment and retirement accounts is Personal Capital. Not only do they have a free fee analyzer, but you can track all your accounts from one handy dashboard.
To learn more and analyze the fees on your accounts, visit Personal Capital to get a free account.
Alright, and we’re back.
Okay, let’s run a sample scenario to see just how powerful the time-value of money is when you accelerate it with pre-tax savings. I’ll detail all this out at below so you can dive deeper into the math.
But let’s assume someone at 30 years old has an existing retirement savings of $15K. They earn $70K per year (for easier math, let’s assume that they never earn pay grade jumps, cost-of-living increases or promotions). They save 10% of their salary, getting a 3% match from their employer for their Traditional 401(k). They work for another 35 years, where they earn a conservative 7% interest rate. They target retirement at 65 and a 30-year retirement until they’re 95 years old. These assumptions also assume that they stop earning returns and growing in retirement, which isn’t realistic, but for today’s calculations, we’re just looking at size of the nest egg when they retire.
First, let’s look at a baseline of someone who is putting their money away into a taxable account, something an account at Betterment, using post-tax dollars. At a $70K salary, let’s ballpark their net take-home pay at around $50K. If they contribute 10% of their net paycheck, they’d contribute $5K per year to their taxable investment account, or $417 per month (let’s round it to $400/month for easier math). After 35 years, the nest egg would be $893K. Using the 4% rule, it would provide $35,720 per year in retirement. Since it grew in a taxable investment account and with post-tax dollars, it is subject to capital gains taxes of 15% (at least today), which would effectively bring the value of the nest egg down to $30,362 net per year.
Now, let’s look at the same scenario, except this time rather than taking 10% of their net paycheck and depositing it into a taxable investment account, they contributed 10% of their salary (pre-tax) into a 401(k) where they get a 3% match. After you take out the FICA tax of 7.5%, means that their contribution is $6,475K per year (we’re going to ignore the match for right now so we can compare apples to apples). We’ll round down to $500 per month. That will land a nest egg of $1.073MM. The 4% rule says that you can safely withdraw $43K per year. After you take out income taxes of around 20% leads to a net income of $34,400. Remember that the first example only landed us $30K, so you can how beneficial it is to have the tax advantage. When you add in the “free money” of the employer match, the 401(k) is an even more attractive option.
What would happen if they waited until 35 to start saving? By waiting five short years, the nest egg shrinks down $731,733, which is over a 30% drop in the size of your nest egg. Moral of the story, don’t wait!
|Taxable Account||Traditional 401(k)||Traditional 401(k) – 5 yrs|
|Time||35 years||35 years||30 years|
|Rate of Return||7%||7%||7%|
|Nest Egg at 65||$893,014||$1,073,120||$731,733|
|Tax Rate||15% (capital gains)||20% (income tax)||20% (income tax)|
Know Your Limits
What’s great about the 401(k) is that there are no income limits to be eligible to contribute. The only limit to be aware of is the annual maximum, which is $18K. If you’re over 50, you can contribute up to $24K.
As I mentioned before, in most cases, you can start withdrawing your money without penalty when you’re 59.5. If you need to access your 401(k) before then, you will pay a 10% penalty on whatever you withdraw, in addition to normal income taxes. Avoid this penalty at all costs. It’s a wealth killer.
There are also sometime options to take a loan from your 401(k), which usually gives you access to 50% of your vested 401(k) balance up to $50K in the form of a 5-year loan. As long as you keep making regular payments, you’ll avoid the 10% penalty. You’re borrowing the principal from yourself, which is better than borrowing from a bank, but you’ll still pay interest on the loan and until it’s paid back, it’s not building wealth for you. This isn’t the worst option is you really need the money, but it shouldn’t be the first (or even fifth) option you consider.
Another limitation on traditional 401(k)s is that you need to start taking Required Minimum Distributions when you turn 70.5. In short, you’ll be required to start withdrawing a set dollar amount every year, whether you need the money or not.
A Word About Management Fees
As you’ve likely deduced by now, I hate fees. It can suck the life force out of an investment account, but sometimes they’re a necessary evil and there’s no way around it in a 401(k) plan where there is only one custodian managing your retirement account. But, just be mindful of the fees you’re paying for the “benefit” of contributing your money in a pre-tax environment. And they don’t make it easy to understand.
With one of my 401(k)s in a previous employer, I needed to ask the Fees Question several different ways before I finally understand that because they broke the fee into quarterly amounts of 0.80% per quarter that it was in fact a management fee of 3.2% when it was annualized. That didn’t include the fees that each of the mutual funds charged as well, which added up to around another 1% as well. That got to be an expensive 401(k), essentially negating any of the company match I was getting on top of my contributions.
I found this to be super shady, because 0.8% doesn’t seem so bad, but if they’d tell you the annual fee schedule, which allows you to better compare that against other investment fees you pay, their 401(k) option doesn’t look so good. Once I learned that, it made for an easier decision to contribute to that 401(k) so I got the maximum company match, but then rather than blindly pumping more of my salary into that 401(k), I chose to invest into my Roth IRA instead, where I had much more favorable fees with investments that were performing at about the same pace as my actively managed 401(k). That’s where being mindful of the fees that get swept under the rug can help you keep more of your returns in your pocket.
That’ll do it for this week’s episode.
What about you? Have you seen any crazy 401(k) setups? Do you have any experience with 403(b)s, 457s or Thrift Savings Plans? I’d love to hear from you.
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For a recap of the strategies, tools and links that we talked about today, check out the show notes at modestmillions.com/005.
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Join me next week when we continue our series on retirement savings and talk about IRAs.
Until then, remember to keep squirreling away now to earn millions later!
Thanks for listening; we’ll see you next time!