The Complete Beginners 401k Guide: Everything You Need to Know to Get Started

There is a crisis in retirement savings in the US. The average 50-year-old American family only has $8,000 in retirement savings. This is not nearly enough money to live on let alone retire on. Maybe they plan on never retiring. Who knows? The 401k is a very powerful investment vehicle and should be used if it is available to you.

To help combat this crisis in savings we have the 401k. The 401k is a very powerful investment vehicle and should be used to boost your savings for retirement.

What is a 401k Plan?

The 401k was first legislated in 1978, but it took awhile to rise in popularity. Today, the 401k is the most popular retirement account in the US, and for good reason.

A 401k is an employer sponsored retirement plan that allows employees to defer a portion of their salary into the plan and invest it. The 401k can take multiple different contribution types depending on the plan rules. Contributions allowed are:

  • before tax (Traditional 401k)
  • Roth 401k (After-tax with tax-free growth)
  • After-tax 401k (after-tax with taxable growth upon withdrawal)
  • Company matching contributions

The before tax (Traditional 401k) contribution is the most prevalent with the Roth 401k option only coming available in recent years. Because all 401ks are by definition employer-sponsored, your employer defines the rules to the plans. Some employers only allow before-tax contributions while other employers may allow all contribution types.

The major benefit of contributing to a 401k is the employer matching contributions. Employers generally do the matching contribution as a percentage of your salary. My employer originally had a matching contribution worded “We will match 1% for each 1% the employee contributes up to 3% and then 0.5% for each 1% the employee contributes up to a maximum of 5%.” In other words, the employer matched 4% for a 5% salary contribution on my part.

Take the time to read the plan rules and the employer matching contribution rules to make sure you get all of the free money available to you. Every plan is different so there can be no general guidance on how much you should contribute. You just need to make sure you get all of the employer match. The employer match is basically free money. There is no easier way to make money than contributing to a 401k.

Contribution Limits

The contribution limit of the 401k is $18,000 of personal contributions in a given year for before-tax and Roth contributions combined. If you are age 50 and above you are allowed an additional $6,000 catch up contribution to help you better prepare for your coming retirement. Company matching contributions to the 401k do not count towards your $18,000 limit. The total limit on contributions to the 401k in a single year is $54,000 or $59,000 if over 50 years old. The high limit on contributions comes into effect when you make after-tax 401k contributions. Included in the upper limit on contributions are all contribution types including employer contributions.

These contribution limits are accurate as of 2017.

Limits for High-Income Earners

In order to stop high-income earners from getting too many tax benefits from the government, they instituted a rule to try to limit the contributions of high-income earners. Because 401k plans usually limit the percentage of income that an individual can contribute, the government has limited the maximum salary eligible to contribute. If you make $500,000, only the first $270,000 of your income is eligible for a 401k plan. If your company limits contributions to no more than 20% then you would still be able to contribute the maximum amount of $54,000 if you desired.

Investment Options

The main gripe many people have with 401k plans are poor investment options. It is sad to say that your investment options are generally limited by the plan rules. The employer, working with their 401k plan administrator, decide on the mutual funds and stocks available to you. Many times the investments available are high fee funds that benefit the plan administrator and not the employee. High fees can destroy your investments and should be avoided.

When looking through the investment options available to you in your current 401k plan, you should look for the ones with the lowest expense ratio. These are usually the index funds and are the ones you will want to be invested in. There is no need to invest in a fund with a high (above 0.5%) expense ratio. The best funds are below 0.1% cost.

For example, my current selection of 401k funds is pretty abysmal. However, there is one total market fund from BlackRock in it that has an expense ratio of 0.03%. Needless to say, I invested all of our 401k money here.

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Distribution Rules

Now the complicated and convoluted part of a 401k is the distribution rules. In general, distributions from your 401k are not allowed unless one of the following has been satisfied:

  • You no longer work for the employer.
  • You reach age 59.5
  • You have a hardship as defined under the plan rules.
  • The plan is terminated.

All of these will allow you to begin taking withdrawals from your 401k, however, you still have to watch out for fees. The only way to take out money unrestricted from your 401k is to reach age 59.5. At that age, you can take withdrawals without concern of the rules. You will have to pay income tax on your withdrawals, so be careful to minimize your taxable withdrawals or you could end up paying a large percentage in tax.

There is a 10% penalty for withdrawal unless one of the below is satisfied:

  • distribution is rolled over to an eligible IRA such as a Traditional and Roth IRA
  • Death or disability of the 401k’s owner.
  • You are 55 or older when you quit your job providing the 401k to you.
  • The 401k owner has deductible medical bills greater than 10% of their adjusted gross income.
  • The distribution is a timely correction of excess contributions.
  • The distribution is not taxable.
  • It is part of substantially equal periodic payment (SEPP) distributions set up for the owners lifetime.

Taking a distribution of your 401k after retirement or leaving your employer and rolling it over to an IRA is the most common type of distribution. You do this to allow you to have greater freedom in choices for mutual funds and stocks. Also, IRA’s generally have lower fees associated with them than 401k plans do.

Pro Hack: Some plans allow for in-service withdrawals. If this is available, you can take distributions from your 401k while working and roll them over to your personal IRAs. You may be able to withdraw only your after-tax contributions and roll them over to a Roth IRA allowing you to contribute nearly $40,000 to a Roth IRA in a single year. Check out your plan rules to see if it is possible.

Loans

You are also able to access your funds through loans while you are working for your employer. This is not a very smart thing to do unless you have extenuating circumstances because you will owe interest on the loan during repayment. You are essentially borrowing money from your future self and then paying a 3rd party interest for the convenience.

Tax Benefit Strategy

With Traditional 401k contributions, you are able to get $18,000 in contributions taken off of your taxes. All after-tax contributions are subject to tax on capital gains upon withdrawal. However, you can roll over your after-tax contributions upon retirement to a Roth IRA with a one-time payment on gains and then be able to get tax-free growth for the remainder of its lifetime. You will realize the largest benefit from this strategy when you leave your employer earlier in life. This strategy gets you the best of both worlds when it comes to slashing your taxes. You get $18,000 off your taxes now and you get all of your after-tax contributions to tax-free growth upon retirement.

You can also pursue the Roth 401k, if available, and get $54,000 per year into a Roth IRA upon retirement. This would all be tax-free money come retirement.

Note: You will have to pay capital gains tax on after-tax contribution growth at the time of rollover.

401k Fees

Beware, beware the fees that come along with 401k plans. Many plan administrators see the 401k as a great way to make some extra money. They stock the 401k with expensive funds and then charge administrative fees on top of that. Also, be on the lookout for plans that may charge transaction/trading fees for your contributions.

Fees can eat quickly away at your earnings in your 401k. Check out the 401k Analyzer at Personal Capital to get a good visual of how 401k fees can affect your future.

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Bottom Line

You definitely want to invest in the 401k if you have the option. If for no other reason, you should be investing for the free money available to you from your employer. In the pursuit of financial independence and freedom, we should take the free handouts when they come. The 401k will help boost your retirement savings and bring about retirement sooner than without.

Do you have a 401k with good benefits? Do you max it out every year? Let’s start the conversation below.

 

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