Your 401k Retirement Plan: What is a 401k?

A 401k retirement plan is, very basically, an investment account funded by direct withdrawals (called “deferrals”) from your paycheck. The largest benefit of a 401k is you do not pay any federal taxes on the money you save, or earn in interest, until you make a withdrawal.

While 401k retirement plans are sponsored by your employer and managed by a third party (Fidelity Investments, for example), a 401k is a self-directed account. You control how much (if any) money you want to contribute to your 401k and your employer automatically takes that money out of your paycheck to deposit in your plan. Your employer may match a certain percentage of the money you contribute to the plan, up to a limit, or may make regular contributions based on your salary whether or not you contribute your own earnings.

Why Contribute to a 401k?

Just 50 years ago, any decent job offered a pension that guaranteed a percentage of your salary (based upon years of service) between your retirement and the day you died. On top of Social Security, which provided a similar benefit to everybody, most hard-workers could look forward to a relatively comfortable retirement without a second thought. Today, this simply isn’t the case.

Pension plans worked when the average retiree lived for just five or ten more years. Fortunately for us, we live a lot longer today. Unfortunately for employers offering pensions (and employees counting on them), those funds have been eaten up by current retirees. Even more frightening, the federal government has acknowledged the same thing will happen to Social Security. To those working today this is a double slap in the face. While existing retirees’ benefits are coming out of our paychecks each month, the likelihood we will receive similar benefits when we retire is dwindling.

With disappearing pension plans and the erosion of Social Security, young workers have two options: work until you die or save for retirement yourself. For most, a 401k retirement plan is the best choice. Why?

Benefits of a 401k Retirement Plan

401k plans offer a number of benefits that you would not get through just any investment account. They include:

Tax Deferred Savings - Your 401k account is not subject to federal taxes until you make a withdrawal. That means that your investments grow tax-free for decades. The catch? If you withdraw from your account before retirement the IRS will hit you up for its share – up to 28% plus a 10% early withdrawal penalty if you withdraw before 59 1/2. There are limited exceptions for 401k hardship withdrawals and 401k loans.

Employer Matching - Though not mandatory, most employers provide some sort of matching contribution or profit-sharing contribution to your 401k plan. When paired with a regular employee contribution, such contributions can effectively increase your salary by several thousand dollars a year.

Large Deferral Limits - As of 2006 the IRS allows employees to defer up to $15,000 or 100% of earnings, whichever is less, into a 401k. Participants age 50 and over can also make “catch-up” contributions up to an additional $5,000 in 2006.

401k Rollovers - Thanks to the 401k rollover; a 401k retirement plan is highly portable. As it is unlikely you will work for one employer throughout your career, it is possible to “rollover” your 401k into a new company’s plan or an Individual Retirement Account (IRA) without incurring any tax penalties.

401k Retirement Plans: Summary

There is no reason not to take advantage of a 401k retirement plan if your company offers one. Read more on Money Under 30 to learn why you must start saving early, learn about unvested money, or use a 401k calculator to determine how much you need to save.

Related Posts

• How to Take a 401(k) Loan - And Why You Shouldn’t
• How Much Should Be In Your 401(k) at Thirty?
• 401(k) Vesting and Changing Jobs: Should You Stay or Should You Go?

A 401k vesting schedule is a common way for employers to provide an incentive for employees to stay on-board for more than a year or two. For the uninitiated, 401k vesting is when an employer makes a contribution on your behalf into a tax-deferred retirement account on a regular basis, but does not give you complete ownership of the money until you have meet certain requirements. While the money subject to 401k vesting earns interest the minute it is deposited, you may not be able to take all of that money with you if you quit before your employer’s allotted period of time.

For savvy workers, 401k vesting schedules are another important reason not to hop from job to job (in addition to the impact on your resume). But is there ever a time to cut your losses and head for greener pastures?

Suppose your employer’s 401k matching and profit-sharing contributions are subject to a five-year vesting schedule. You have worked there for two-plus, still enjoy the job, but have received a competing offer at another company.

Suppose your present company offers a 50% match on up to a 6% contribution to an employee’s 401(k), and an annual profit-sharing bonus that is deposited into the same account. Both of these benefits are subject to a five-year vesting schedule in which you own 20% of all monies contributed for each calendar year of employment. In other words, once an employee begins to contribute to his or her retirement fund, the full benefit won’t actually be realized until the employee’s fifth full year of work.

Further assume your current salary is $34,000 and you receive the maximum 3% 401k matching contribution from your employer and have received one profit-sharing deposit of $460. The current employer-contributed balance of your 401k is approximately $2,410 ($1,910 match + $460 profit sharing). If you were to resign work today you would only keep 40% of that ($964) due to the vesting schedule.

Assuming your new employer has a similar retirement contribution plan that you can enroll in immediately (not always the case), you would be leaving the unvested portion of this money on the table ($1,446). So you would need to make a salary of just $500 more per year to break even over the next three years, right? Not so fast. When you throw in the fact that the $1,446 is tax-deferred AND has the potential for returns, it’s not so easy.

If you could earn a 15% annual return on that money (difficult but not impossible with aggressive investments), it could actually be worth $2,200, or $754 more. So you would need to earn about $730 more a year, after taxes, (about $900 pre-tax), to do better than this money. So if you are offered a job with a salary of just $1,000 more, you can justify leaving your unvested 401k money behind.

But what if the new employer doesn’t offer retirement matching or delayed eligibility?

In this case you would have to consider the money your current employer deposits into my 401(k) as part of your actual salary, upping it by about $1,500. Add the amount required to break even with your unvested funds and you get $2,400. All other things equal, you would have to make more than $36,400 at a new job for it to be a fair trade. Chances are you wouldn’t consider trading in a job you like for much less than a 10% salary increase anyway, but it is helpful to know, numerically, a minimum acceptable salary.

Bottom line? 401k vesting provides a strong employee incentive not to make a lateral career change outside of the company but does little to thwart a competing job offer that dwarfs a worker’s current salary.

Thanks to AllFinancialMatters for pointing out this story from MSN Money featuring some average personal finance statistics of people in their 20s. For example, our median net worth is $7,901, but for nearly 25% of us, that figure is negative. We owe more than we own!

These numbers are exactly why I created this site! Immediately upon graduation I fell into the trap of living like an adult even though I was earning like a graduate… A few years later and I am really in the hole. But as the MSN story points out, I am young enough to recover from my mistakes. With some planning and hard work I will be out of debt and have a healthy 401(k) before I turn 30. Obviously this site is all about how we can all do the same, but in a nutshell there are three rules that will be repeated here over and over again!

• Kill Your Credit Cards: High interest credit card debt has to be the first to go. Use all available resources to rid yourself of this debt as soon as you can.
• Save for Retirement: Check out the calculator at AllFinancialMatters showing how much more you will have to save each year if you postpone starting your 401(k) or IRA.
• Live Below Your Means: Once you pay off your consumer debt, you must spend less than you earn to avoid going back in the red! Keep only one credit card for emergencies that must be paid off every month. Create an emergency fund with the money left over each month to fall back on in emergencies. Use this site’s budgeting tool to help track your spending.

Q: I just started my first full-time job but am not eligible for the company sponsored 401(k) until December. What should I do if I want to start saving for retirement now?

A: It’s a great idea to get a head start on your retirement saving even if your employer delays the onset of its retirement benefit. In most situations, a traditional IRA (Individual Retirement Account) is the best solution for young, independent retirement savers. IRA contributions not only grow tax-deferred, but are tax-deductible up to $2,000 per year.

Almost any financial institution (including, most likely, your local bank), can set up your IRA, and many will waive minimum balances if you agree to have monthly contributions automatically deposited into your account. As with opening any retirement planning account, there will be a seemingly daunting variety of investment options available to you. Especially as you just start out, how you decide to allocate your savings is far less important than the act of saving something. If possible, choose a pre-designed aggressive portfolio.

As a young investor you can better tolerate the risks inherent with aggressive investments but stand to be rewarded further down the road.

Once you become eligible for your 401(k), contribute to both. That way you can take advantage of any matching contributions from your employer and the IRA tax deduction.

The Automatic Millionaire Workbook is the follow up to Personal Finance Guru David Bach’s best-selling the Automatic Millionaire. Both books cover the same material, with the workbook providing exercises to evaluate your financial situation and implement your personal plan.

Bach’s anecdotes about his clients’ success stories are motivating and I agree with his concepts, though I think some are better suited for people who have “settled down”. If you’re like me, moving and changing jobs every couple of years, it’s a bit trickier to put all your bills, savings, and investments on autopilot. What worked one month may not the next.

Bach’s advice can be summed up as: find and eliminate your “latte factor”, pay yourself first, make it automatic, and own your home.

Bach has trademarked the “latte factor”, but economists have been onto this principle for years. Basically, tiny purchases you make everyday, such as coffee, cigarettes, or candy bars, seem diminutive, but over time add up to staggering amounts. Eliminating these daily costs is an important step toward long-term wealth.

Pay yourself first is taking money from every paycheck, for retirement and an emergency fund, before you pay a single bill. Making it automatic is the use of payroll deductions or previously-scheduled electronic bank transfers to save and pay debts before you see a single penny in your checking account. I have been using this for a few months and have already been impressed with how much faster I am paying off my credit card. Though the monthly amount I am paying hasn’t changed, I no longer skimp out on a payment some months because something else came up that I used the money for.

Finally, Bach insists that everybody should own their home. Again, it’s hard to disagree with him here, but for many young professionals home ownership is so far away it’s almost laughable. Certainly it is a good reminder of an important long-term goal.

I would recommend both the Automatic Millionaire Workbook or the Automatic Millionaire for anybody looking for a system to simplify the difficult task of getting out of debt and saving for retirement, with the understanding that the younger you are, the less you may be able to implement right away.

Millions of young workers graduate in debt and wonder: When I become eligible for a 401(k) or another tax-deferred retirement plan, should I contribute to the plan even if I could use those funds to pay down debt?

Of course, the answer is “it depends”. Looking solely at the numbers, few things are more important than paying off credit card debt as quickly as possible to avoid throwing money away on the exorbitant finance charges, so it seems starting a retirement plan would be out of the question until your debts are gone. But human beings are not robots, and the psychological benefits of getting into the habit of saving and watching your investment grow are important. Remember also the financial benefits of starting a 401(k):

1. Compounding Interest – They say a dollar invested when you are 25 is worth two, or five, or even ten invested when you are 40. The longer you wait to start saving for retirement, the more you have to contribute annually to achieve the same results. Even with large balances on high interest credit cards – assuming you can still maximize your payments to rid yourself of these debts as quickly as possible, the 6% or so of your salary will be well saved in your retirement plan.
2. Employee Matching – Many, but unfortunately not all, employers will match all or a portion of your annual retirement contribution. Most employers will cap the percentage of your salary they will match. For example, my current employer matches 50% of my 401(k) contribution up to a maximum of 6%. That is, if I contribute 6% of my salary in 2006, they will put in an additional 3%. If your employer offers account matching, this is a definite reason to contribute, because not contributing is like saying “no” to a 3% raise!
3. Tax Deferral – The other enormous benefit to retirement accounts is that you don’t pay a dime of tax until you retire (unless you cash them out early)! Basically, you get to keep a bit more money if you make tax free contributions to a retirement account than if you took the money as cash.
4. Automatic Withholding – Let’s face it, I wouldn’t be in this mess if I had shown the discipline to save on my own. Even as I train myself to do this going forward, I like the fact that the money is deposited into the account before I even see it. If I had to put it towards a loan myself, who knows what else might come up that I would impulsively use it for.
5. Withdrawal Penalties – Like the withholding, this is a good safeguard over impulsive withdrawals. Many employers will not let you even withdraw from a 401(k) while you are still employed, and if you choose to do so after terminating your employment rather than rolling the account over, you are taxed on the account as income AND face a 10% penalty. There are a million other reasons not to touch your retirement money early, but those are pretty good ones as well.

An artlice from Sunday’s Boston Globe (story) got me thinking about the principle of consumption smoothing for the first time since I took Econ 101 about seven years ago. If I remember correctly, it basically states that after reaching a certain age or point in life, our the things we need to buy begin to taper off until they reach a constant annual level. For example, when we first buy a house we need furnishings to go in it and tools to take care of it. As we accumulate these things, however, we won’t need to buy them again. For most people, once the house is paid for and the kids out of college, our annual living expenses are much less than they once were, and they tend not to fluctuate.

On the flip side, however, is the undeniable truth that as young professionals, our consumption habits are growing, not smoothing. The trick is to keep their growth in check so that it does not outpace our earnings, or the result is debt. (Or more debt, as the case may be).

The reason I wanted to post on this, however, is the motivation this principle SHOULD present to us twenty-somethings to get out of debt now. Our consumption curves are still climbing. Until we buy a home and have kids, we have a lot more spending ahead of us. All the more reason to take the extra money we have now and save it or pay down debt so that we will be in sounder financial shape when it comes time to make the big purchases of our lives.