The best resource on 401k for beginners, including the advantages and limits of this savings program. Read my tips & techniques for maximizing your 401k savings.
You’ve finally entered the workforce with your first real corporate job.
But there’s so much to learn, right? You gotta get to know your new boss and your new teammates, learn how to use the company tools & software, even figure out what the best times are — for you to use the office restrooms. And beyond that, you still have to sign up for your health benefits, make your insurance elections, and most importantly, learn how to set up and take advantage of your 401k plan.
Your 401k is an essential part of your compensation package — and if you start early enough, it can be an amazing tool to help you save a large amount of money towards your retirement.
So in this article, I’ll be going over all of the details of what a 401k plan is and sharing a few quick tips on how to get the most out of this program — so your money can grow & you can earn the most profit by the time you reach retirement.
What is a 401k?
401k defined: A savings and investing plan offered only through your employer, to help you save for retirement.
These company-sponsored 401k plans generally operate by 3 simple steps:
- Register for a 401k account through your company’s brokerage firm
- Set up a payroll deduction process to automatically contribute to your 401k through your paycheck
- Select a contribution amount and determine your investment options
The first thing that happens when you decide to enroll in your company’s 401k plan, is that your company asks you to register an account with their partnering brokerage firm.
It’s usually one of these main players in the financial services industry and you’ll probably be given an online registration form to fill out at work, that is specific to your company’s particular 401k plan.
Now once you’ve gotten your account set up, the next step is to sign up for the process to contribute money to this account — which is typically done through a function called “payroll deduction.”
The way most corporate 401ks work is that every paycheck, your company will automatically deduct whatever percentage you elect to put into your 401k, and send it directly into your retirement account. And it’s done through your employer’s payroll process, which is why it’s call payroll deduction.
Lastly — in addition to deciding how much you want to contribute (from each paycheck), you also have to decide what investment options you want your money to go into. There are many options to choose from and both the brokerage firm and your company may give you some additional research to help you learn more about each fund option. And it doesn’t have to be all one choice either, you can choose to invest in multiple funds — and you can decide what percentage of your contribution gets allocated to each option, as well.
So now that you know the basics of what a 401k plan is and how to enroll in the program, let’s talk a little bit about the advantages and disadvantages of this particular retirement account.
THE ADVANTAGES OF A 401k
1. First, to encourage more people to save towards their retirement, the IRS gives you a tax deferral on the money you choose to put into your 401k. What this means is that you don’t pay any taxes on the amount you contribute to your 401k until you decide to withdraw that money later on in retirement. And that’s because contributions to your 401k account are considered pre-tax events, which is fantastic! Any time we pay less taxes, it’s already a win for us!
2. Secondly, as I mentioned before, to help your money grow in these retirement accounts, your employer will usually partner with their brokerage firm to offer you a set of custom investments vehicles for you to bank your money into — like target-date funds, mutual funds, bonds, etc. These funds are usually designed to be the most optimal blend of risk & return to allow your savings to grow, without you having to actively manage it. So you can set it up once and forget it.
3. The third benefit, and probably the most straight forward, is that most companies (but not all) will provide you, what is called, a company match, for the amount of money you contribute to your 401k. What this means is that for every dollar you decide to put into this account, your company will give you some type of match — and deposit that matched amount directly into your account, as well. Usually, this is a small percentage, like 3%, or 5% of your contributions and there are typically some qualifiers like they only match 50 cents for every dollar you put in — up to 3%, or they only match up to a certain total dollar amount, etc. But, no matter what the stipulations are, this is a great benefit, because essentially, this free money that your company is giving you, just to reward you for thinking ahead and taking action towards your retirement.
Now that we’ve talked about the benefits — here are a few disadvantages that you have to keep in mind, as well.
THE LIMITS OF A 401K
1. First, to make the benefits of 401k (especially the tax deferral part) fair for everyone regardless of their income levels, the IRS limits the amount of money you can contribute to a 401k, in a given year. And each year — the limit changes, but as of 2020, that limit is $19,500 — which means whenever you’ve hit a total of $19,500 in payroll deductions towards your retirement account, your contributions will automatically stop — for the rest of the year.
2. Secondly, to help you preserve this retirement nest egg for the future, the IRS has a rule that says you must wait until AT LEAST age 59.5 before you can pull money out of those funds. It’s kind of like when you were a kid, and you accidentally found your Christmas presents in the closet and when you asked your parents about it, they took it away and wouldn’t let you look at it until Christmas — yeah, it’s sort of like that.
Now technically, if you really did want to pull money out of your retirement account earlier than age 59.5, you could do so — but you’ll have to pay an additional 10% penalty fee in addition to all of the taxes that apply to that income, so you should think twice about doing this unless you absolutely needed to.
3. The third thing to be aware of is that all of the income you pull out of a traditional 401k — is subject to tax at the point of distribution. So what does that mean? Remember in the beginning when we said that the money you put into your 401k plan from your paycheck is not taxed by the government? Well, that tax deferral only exists if you keep your money sitting in that account — the moment you decide to start pulling out those funds, in retirement, the government will come in and ask for their piece of that pie. Basically, when you pull your money out, the government treats that like any other form of income — so you have to pay taxes on it. But you get taxed WHEN you pull it out at whatever tax bracket you reside in THEN. So, in the future when you’re retired, if you happen to fall into a lower tax bracket than you are in now, you would effective end up saving money on taxes.
Ok — so now that we’ve reviewed the basics of the 401k, here are 3 quick tips on how to maximize this program to your full advantage.
401K Tips for Beginners – 3 quick tips to take full advantage
- First, make sure you are contributing, at a very minimum, the total amount you need put in, to get the full company match in your account. It’s free money and there is no reason not to claim all 100% of it. In fact, as I mentioned before, it’s part of your compensation package at the company — so if you don’t take full advantage of this, it’s kind of like giving yourself a pay cut, at the end of the day. Beyond that, the most optimal thing you can do for the long term is to try to invest up to the total IRS contribution limit because that gives you the most tax savings for the year — and the more money you put in upfront and the longer you keep it in there, the faster it grows.
- Depending on your income level and what your tax filing status is, by contributing to your 401k, you could be eligible to receive something called a Saver’s Credit which would give you a tax credit, of up to $2,000 at the end of the year, when you file your taxes. To be eligible for a savers credit, you have to:
a) Be over 18, and not counted as a dependent on anyone else’s tax filings
b) Not be a full-time student
c) Fall within one of these 9 income brackets in this chart (if you fall into the last row, you are not eligible for a Saver’s Credit)
Depending on where you land, you could receive either 10%, 20% or 50% of your 401k contributions back at the end of the year, when you file your taxes.
Now, one really important call out to make here is that this Saver’s Credit is a tax credit, not a tax deduction.
The difference between the two is that a tax deduction lowers the total amount of income that is subject to tax by the IRS in their tax calculations and a tax credit reduces the actual taxes owed.
So for example, If my total income this past year was $50k, but I have a tax deduction of $5k, then the adjusted gross income amount that the IRS would base their tax calculations on, would be $45k. Now, if I’m taxed at a 15% tax rate, then my taxes would come out to be $6,750. This is a tax deduction scenario, so there is no tax credit — which means my final taxes owed would be the same $6,750.
Now, let’s see what it would look like if I had a tax credit of $5k instead. First I’ve made the same $50k in income as last year. But this time, since I don’t have a tax deduction, my adjusted gross income stays the same $50k. At a 15% tax rate, my initial taxes owed would be $7,500 — a lot higher than the tax deduction scenario. But since I have a tax credit of $5k and since tax credits apply directly to the amount of taxes I owe, the actual amount of taxes I would pay is reduced to$2,500. See how this works? A tax credit is much more valuable than a tax deduction — and that’s what you would get with this Saver’s Credit, by simply contributing to your 401k.
3. My third tip on maximizing your 401k — is to invest early, and hold it for a long period of time. Now, I know that this is really simple and straight forward — but it’s important to say. If you’ve never heard this before, you might ask, “Daniel, what’s the point of saving in my 401k early if all it is, is a savings account that just delays my paying taxes on it until later in retirement? What’s the point of saving early anyways?” And the answer would be a magical little thing — called Compound Interest.
What is Compound interest? The simplest way to define Compound interest is to think of it as interest earned on your original investment plus all of the interest earned on the interest that has built up over time.
Here is a quick example of how this works.
Let’s say you start your 401k with $10,000 in your account, and each year you receive a 10% gain on the value of your account. For year 1, since you have $10k in the account, your 10% growth would be $1,000.
Now, if I let that $1,000, stay in my account, then I start the next year with $11,000 in my account, right? Let’s say in year 2, I see the same 10% growth — but the difference is that my starting account value here, is $11k, which means 10% of that is $1100.
Let’s say that I keep that $1,100 in my account again — then I start year 3 with $12,100 in my account right? The same thing happens again, I see a 10% growth in the market, but this time, because I have $12,100 in my account, the 10% growth, this time, yields $1,210.
As you can see, the value of my yearly gain (or interest) keeps rising and rising — because each year I’m getting a little bit more and more and it keeps building into this powerful process that keeps giving me interest not only on my initial investment, but on the interest that has built up over time. (If this is hard to follow on paper and you’d like to see this example visualized — click here.)
If I follow this pattern and fast forward to year 10, the gain that I see is now over $2,300 and the value in my account is more than double my initial investment. See how this works?
This is exactly the way your 401k will operate, because each year, your portfolio growth will not only build upon your original investment, but on all of the previous yearly growth as well — that is the magic of compound interest.
So what that means is that if you consistently invested $5,000 each year into your 401k, with a company match of just 2% and you did this without interruption for 15 years with a modest market appreciation of 7% each year, at the end of year 15 — you would have over $130k dollars in your retirement account!
But if you did the same thing — $5,000 per year contribution at a 2% company match with a modest market appreciation of 7% but did this without interruption for 40 years, you would have well over $1M in your account!
Time (especially in the later years) is the most important thing when it comes to compound growth — and that is why starting as early as you can, is the most important thing here.
Now, these figures are not even considering any type of pay raise or bonus you might have gotten within your 40 years of employment that might have caused you to increase your 401k contributions. So, it definitely pays to start your 401k early and put in as much money as you can early on — make sense?
So I hope this information was helpful to you — and it gets you started on the road to investing for your future, through your 401k!
Remember — no one will be accountable for your financial future, except for yourself. Plan ahead and make sure you take care of your future self.
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The content here is strictly the opinion of Daniel’s Brew and is for entertainment purposes only. It should not be considered professional financial investment or career advice. Investing and career decisions are personal choices that each individual must make for themselves in accordance with their situation and long term plans. Daniel’s Brew will not be held liable for any outcome as a result of anyone following the opinions provided in this content.