There is a reason why the famous 401(k) continues to be the most searched financial term on the internet, and it’s not because everyone wants to know what it wore last night on the red carpet. I pride myself in knowing more than most on financial topics such as this, but as I dove into this topic I learned a few things I didn’t know before. So, in the spirit of learning, I’m going to write a couple posts on this recluse 401(k) and hopefully help you understand him more.
What is a 401(k)
I leaned over to my wife and asked her “What is a 401(k)” and she answered exactly as I would imagine a creative, 20 something would answer “It’s a place for your retirement savings.” Perfect, she is exactly right. Except, if you called a Swiss Army Knife just a “knife,” you would be missing out on all of it’s features. Same with the 401(k).
The problem with googling, “What is a 401(k)” is that you get definitions like this one at the very top, and in the next five articles too: “A 401(k) is a retirement savings plan sponsored by an employer. It lets workers save and invest a piece of their paycheck before taxes are taken out. Taxes aren’t paid until the money is withdrawn from the account.”
Sounds simple right?
First off, the definition doesn’t even mention why a “retirement savings plan” is named with numbers and a letter in parenthesis. So let’s start there.
Why is it called a 401(k)?
The name comes from the IRS tax code. Yes, THAT IRS. The one that knocks on your door every year asking you to prove that you paid them enough money throughout the year. 401(k) is a subsection in the tax code (the tax Bible) that says an employee can take some of their paycheck out to put into this account BEFORE we tax it. We are getting a little ahead of ourselves, but you get the point. It has a funny name for a reason and now you learned something.
Is it really a “Retirement Savings Plan?”
Don’t let the (almost) 3,000,000 google definitions fool you. This retirement savings “plan” is by no means a “plan” for you. In financial advising, you need to be a certified financial planner to even call something a “plan,” and this is not even close to what you would think a plan is.
If you were going to build a house and the only “plans” you had were your bank account and that bank account was nearly empty, your house will not be built. Please don’t take what you read on the internet as literal as it seems.
An October 2017 Study by the Index Annuity Leadership Council (IALC) tells us that for every five people that own a 401(k), one of those people truly believes that it will give them guaranteed income when they retire! Please don’t be one of those people. A 401(k) is not a “plan” for your retirement.
A 401(k) is an account that you own, once you start to put money into it. This is not a “plan” for your retirement. It’s a place you put your money into to save for your retirement. Savvy? No action plan telling you what to do with this money. There is no elf standing at the doorway when you put your money into it holding your hand and guiding you to the pot of gold. This is an account you put your money into – in the simplest terms.
Which leads me to the next part of this definition.
Sponsored by an employer – Sweet! That means they’ll give me free shirts and stickers right?
“sponsored by an employer.” what this means is in order for you to own a 401(k) you need to be employed. You can also own one if you are self-employed. In this instance you are sponsoring the plan yourself (sorry no free shirts).
Being sponsored by your employer means you can’t place money into a 401(k) if you are a drug dealer and you don’t pay taxes. If you work for a new up and coming marijuana distribution plant and everything is paid in cash, you cannot contribute to a 401(k) (at least in 2017, you can’t). You need to be an employee that pays taxes in order to own a 401(k).
Before taxes – sounds like heaven right?
“It lets workers save and invest a piece of their paycheck before taxes are taken out.” Sounds simple right?
Let’s break this down one more level.
When the company you work for pays you, the very first thing they do before they hand you the check (or direct deposit it) is take a portion and give it to uncle Sam for your taxes. I’m sure you knew this, but I wanted to make sure. That means, the money you receive into your bank account has already been taxed. This money in your account is considered “after tax.” What a 401(k) allows you to do is say, “WAIT! Don’t tax those dollars I earned just yet!”
If you tell your employer that you would like money that you make to go into a 401(k), they will add a step before your taxes are taken from you. They will take the desired portion (up to a max) and put that into your 401(k) account – PRE-TAX. Now, the money that is left over will be taxed and then put into your account.
The best part about this is, taxes work as a percentage. So, if you have a lower amount (because you put it into a 401(k)) you pay less in taxes. Clear as mud? Good.
Wait, we still have to pay taxes on it?
“Taxes aren’t paid until the money is withdrawn from the account.” This is straight forward, but there are guidelines on when you can take this money out. To put it simply, remember when you got a little tax break for putting money into the account? Well, eventually Uncle Sam wants to tax that money. He ends up taking the taxes from when you start to withdraw money from it.
The reason you would do this is to get a tax break when you most likely need it most (when you are working and growing your income). The idea behind deferring it to when you are older or retired, hence the name “retirement account,” is that you will hopefully be in a lower tax bracket when you are older and you won’t have to pay as much.
Unlike other investment or retirement accounts, you also do not pay for the growth within the account. So if you invest in some awesome growth funds within this 401(k) and they shoot through the roof, you don’t have to pay Uncle Sam on that growth until you decide to. Not bad eh?
In the end you pay tax on this money, so what is the point?
One big reason why most employees put money into a 401(k) is because of “the match.” No, not the dating site. “The Match” is the money that your employer puts in to your account and it matches what you put in. YES, this is FREE MONEY!
Quick example. If your employer says “We will match up to 3%.” This means, if you are making 100,000 and you put in 3% of your income a year into it, they will match it dollar for dollar. If you put in $3,000, which is 3% on $100,000, your employer is required to put in $3,000. This results in your 401(k) being $6,000 for that year. Sweet deal right?
You think this is too good to be true? It’s not. Yes, there are some guidelines with some accounts, but in the end this is free money. Please look into “The Match” with your employer to see how much they contribute. If they aren’t contributing and they are not participating in “The Match” for you, I would take a deep dive into if it makes sense for you to put any money into this account or think about a regular IRA or even a roth IRA. If they do match your contributions, I would take advantage of this “free” money.