Previously, I had talked about the importance of saving early and retirement vehicles such as a 401K. However, I didn’t go into too much detail about how they work, why they are important, and how they can help you. According to a Vanguard study, the median 401K balance of someone from the ages of 25-34 is just over $9,000. For someone from the ages of 35-44, the median balance is just over $26,000. In my opinion, those are very abysmal amounts especially considering the benefits of using one of these vehicles. If more people understood the importance of a 401K and all the benefits they bring, I’m sure that they would make a greater effort to contribute more. If you don’t have access to a 401K account, don’t worry, there are other tax advantaged retirement accounts that I will mention later.
What is a Traditional 401K?
A Traditional 401K is a tax deferred retirement account sponsored by your employer. It allows you to contribute money directly from your paycheck before any taxes are taken out. In fact, you don’t pay any taxes until you withdraw money during your retirement. As a result, you are able to contribute and invest a greater amount of money than otherwise possible if you had to pay taxes up front. In this article, I will specifically be writing about Traditional 401Ks and not Roth 401Ks.
Once you put money directly from your paycheck into a 401K, that money gets invested into a fund of your choice. Target date retirement funds are very popular with 401Ks due to their simplicity, diversification, and automatic allocation. There are many other funds that you can invest in as well.
What are the Limitations?
As of today, you are only allowed to contribute up to $18,000 a year into your 401K. The government limits the amount of money we can contribute to prevent us from avoiding or deferring too many tax dollars. Thankfully, $18,000 is still a sizable sum that will allow you to grow your nest egg over time.
Another limitation is that you are not supposed to withdraw before retirement age in most cases. If you do withdraw before retirement age, you’ll be hit with a 10% penalty on top of the typical taxes upon withdrawal. The intent of the 401K is to encourage you to save for retirement, therefore there are penalties in place for early withdrawal. That is not to say you can’t withdraw early if the math works out for you. A 10% penalty may be a reasonable penalty to pay depending on your financial and life situation.
Why are 401Ks so beneficial?
They are beneficial for several reasons. First, you have the tax deferral mechanism. If you are in the 25% tax bracket, you are essentially avoiding 25% of taxes on any realized capital gains from your investments. If you earn $1,000 from your gross wages, you will pay $250 in taxes, leaving you with $750. Then if you invest that $750 and earn 8% in your first year, you would have earned $60. Once you sell or realize that gain so you can use the cash, you would have to pay a 25% tax on that earnings of $60, or $15, leaving you with $45. At the end of the day, you would have $795.
On the other hand, with a 401K, if you earned $1,000 in gross wages, you would contribute the full $1,000 to your account since the taxes are deferred. Then assume that the market returns 8% like in the previous example. You would have investment earnings of $80, resulting in a total sum of $1,080. Assuming you are of retirement age (this is a hypothetical situation), you could withdraw that entire $1,080 and pay 25% taxes, leaving you with $810. That $810 is almost 2% more than the $795 that you would have ended up with if you didn’t use a 401K. Although that amount may seem small, that type of tax deferral on compounding investment returns over many years will add up.
In other words, your investment earnings and capital gains get taxed once in a Traditional 401K instead of twice if it were in a post-tax account.
In addition, many company 401Ks come with a company match. In other words, the company will give you free money if you contribute some of your own money towards retirement. I’ve seen many companies offer a match of up to 3% of your salary. So, if you earn $60,000 a year and contribute at least $1,800 to your 401K, your company will give you another $1,800. If you max out your 401K at $18,000 for the year, that’s essentially a guaranteed 10% return on your entire contribution. Pretty much no investment out there can guarantee that you get a 10% annual return. Your employee match essentially guarantees 10% per year, and that doesn’t even include any market returns or “returns” by deferring taxes.
So, in my example above, I am assuming that your portfolio returns on average 8% a year, which is fairly standard. If your employer matches a fairly typical 3% of your $60,000 salary ($1,800), you’ll add another 10% return at least (if you contribute less, your investment return percentage may actually be higher since you are dividing the same return over a smaller contribution). That’s almost a 20% average return every year before accounting for the additional return from avoiding a layer of taxes on your investment gains. That is more than double the market average with no work and no need to understand difficult investment principles. That is 20% that the average person can achieve. Any hedge fund, investment fund, or mutual fund would be ecstatic to receive 20% annually. Your government and employer are actually helping you beat the overwhelming majority of investment professionals out there!
Finally, 401Ks are a way to force you to save money without you even having to think about it. It is similar to how your mortgage payment forces you to save money by building equity in your house. In a way, it is an automated savings vehicle and a habit. The money is automatically deducted from your paycheck. Your job will just be to work your budget around the money that is left over after the 401K deductions.
What if You Don’t Have a 401K?
Traditional IRAs and Roth IRAs exist to provide you tax advantages as well. They are owned by you and not sponsored by any employer However, you are limited to contributing up to $5,500 per year.
Teachers and government workers also have their own plans. Check out my post on various retirement vehicles here for more information.
Hopefully I’ve convinced you that Traditional 401Ks (or any tax-advantaged account) are awesome and that you should be contributing as much as you possibly can. I’ve heard people say that you should be contributing at least 10% of your salary towards retirement. Other people say that you should be contributing at least the company match. Whatever you are able to contribute, I challenge you to look for ways to contribute even more.
Professional Development and Personal Finance Blog