So Your Company Offers a 401k Plan.. Now What?
What is a 401k?
A 401k is a retirement savings plan offered by many employers.
The “401k” part comes from the specific tax code that governs the accounts with unique tax benefits.
If your company offers a 401k plan, they have a partnership with an investment firm that allows them to provide the plan.
You can set up an account with the partnered firm and set a percentage of your paycheck to be invested into investment funds.
The best part about 401k plans is that you don’t need any investment experience to start putting your money to work in the stock market.
How do 401 Plans Work?
401k plans are restricted for retirement, so you will not be able to withdraw from your 401k penalty-free until you are 59.5 years old.
There are exceptions to this rule, however. Such as using your 401k to pay for unexpected medical expenses, disabilities, or even preventing eviction or foreclosure.
Suppose you do have to make an early withdrawal (before the age of 59.5) from a 401k, and it is not considered a “Hardship Withdrawal.” In that case, you’ll typically be on the hook for a 10% early withdrawal penalty and any income taxes you may owe on the money you withdrew.
So yes, you can still withdraw from your 401k at any time, but you will have to pay a penalty fee if you are not at least 59.5 years old or have a qualified “Hardship Withdrawal.”
What are the benefits of a 401k?
401k accounts can offer several benefits. Some of those benefits include:
Employer match (essentially free money)
Can lower your taxable income
Easy investment options
Sheltered from bankruptcy or lawsuits
What is a company match?
If your employer offers a contribution match, it’s essentially free money.
This is where your employer will match the amount of money you contribute to your 401k (up to a certain amount).
Let’s say your employer matches up to 6% of your 401k contributions.
If you make $60,000 each year and contribute 6% to your 401k plan (6% of $60,000 = $3,600), your employer will also contribute $3,600 to your plan.
You contribute 6%: $3,600
Your employer contributes 6%: $3,600 (essentially free money)
Total contributions: $7,200
Traditional 401k VS Roth 401k
A key benefit of 401k accounts are the tax benefits.
There are two types of 401k accounts.
Traditional 401k (pre-tax contributions) and Roth 401k (post-tax contributions).
Traditional 401k:
In a traditional 401k, your investment contributions are taken out of your paycheck before the IRS takes its cut. While this reduces your taxable income now, you'll pay taxes when you withdraw the money in retirement.
Roth 401k:
In a Roth 401k, your investment contributions are taken out of your paycheck after the IRS takes its cut. All the assets you buy within a Roth 401k account will grow tax-free.
Your 401k is sheltered from bankruptcy and lawsuits
If your finances take a turn for the worse, creditors and lawyers can’t touch your 401k. (Not that you want to deal with either of those situations..) Your retirement plan is protected by the Employee Retirement Income Security Act of 1974 (ERISA).
(An exception: The IRS or your Spouse can make claims on 401k money.)
What should I Invest in within my 401k?
A 401k plan typically offers multiple investment fund options. The amount of the options provided depends on the investment firm.
Keep in mind: Everyone has different investment goals and risk tolerance. How you set up your portfolio will differ from how I set up mine. The information below is meant to be used as a starting point for your research.
Here are some questions to consider before selecting a fund:
What are your financial goals? (If you want higher returns, you’ll want to be more heavily allocated in stocks.)
What is your risk tolerance? (Are you able to stomach the inevitable volatility of the stock market? If not, you may want to consider taking a more conservative investing approach.)
How long do you plan to invest? (A longer time horizon means you can generally afford to take higher risks and potentially generate higher returns.)
Here are some popular funds most 401(k) plans offer:
S&P 500 / Large-Cap Stock Fund (Offers exposure to the largest companies in the USA, typically seen as a good long-term investment option with average stock market returns.)
Small-Cap Stock Fund (Offers aggressive growth but comes with higher risk.)
International Stock Fund (Offers exposure to companies outside the United States. A great way to further diversify your portfolio.)
Total Bond Market Fund (Offers exposure to various bonds across a wide range of maturities. Bonds are generally considered more conservative investment options.)
Target Date Funds (These allow you to select your estimated retirement date, and a fund manager will allocate your money between growth and conservative investments to optimize your investment time for growth based on your age.)
What happens to my 401k if I leave my job?
If you leave a job, you have two options. You can roll over your 401k into an IRA account, or if your new company offers a 401k, you can roll it over into your new 401k account.
Rolling over a 401k account is as simple as calling the company that manages your 401k plan and requesting your account to be moved to a new account.
What are the downsides to a 401k?
Although there are several benefits with 401k accounts, there are also some downsides to consider. Here are four downsides you should be aware of:
1. Higher Fees
One of the most significant downsides to 401k plans is the high fees. The 401k administrator will typically charge an annual fee. It could be a percentage of everything you have invested or a fixed fee.
In addition to the administrative fee, the funds you can invest in will typically have higher fees than average.
The average total 401k plan fees range anywhere from 0.37% for the (largest plans) to 1.42% (for the smallest plans), according to a CNBC article.
2. Limited Investment Options
What you can invest in will typically be limited in 401k plans. You will usually only be able to invest in a few funds, not individual stocks, and those funds will usually be limited.
According to FINRA, “Most 401k plans provide at least three investment choices in your 401k plan, but some plans offer dozens. The average plan offers between 8 and 12 investment options.”
On the bright side, almost all 401k plans have some S&P 500/large-cap fund, which is my favorite way to invest.
3. A wait until you can keep company contributions
Unless your company’s 401k plan offers 100% vested contributions right off the bat, you may have a “waiting period” until your employer contributions are entirely yours.
When employer contributions to a 401k become vested, it means that money is now entirely yours.
If you leave a company before all of your employer contributions are 100% vested, you may lose out on some of the money your employer contributed.
4. You may be forced to withdraw your money after a certain age
401k accounts also have required minimum distributions starting at age 72, which means you will be required to withdraw a certain amount of your investments beginning at 72.
This could make it tricky tax-wise if you’re pushed into a new tax bracket due to forced withdrawals, social security, and any other assets you might have at retirement.
However, you can avoid the forced withdrawal requirements by rolling a 401k into a Roth IRA, which does not have mandatory withdraws.
What do I think about 401k accounts?
I think taking advantage of any 401k employer contribution match is a must.
It’s essentially free money from your employer and a 100% return on whatever you invest into the plan.
Yes, 401k plans will tend to have higher fees, but the employer contributions tend to make up for the higher fees.
If you ever leave your job down the road, you could always roll over your 401k to an IRA to save on fees and have more investment options down the road.
Unless you’re looking for additional tax benefits, I would only invest up to your employer’s match and invest the rest of your money in either a traditional IRA or Roth IRA.
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As Always: Buy things that pay you to own them.
-Josh
Blog Post: #032
