Understanding your 401(k)
If you have a full-time job, I’m willing to bet you have a 401(k). These retirement plans are the most prolific benefit and are offered by 90% of all large companies. If you haven’t heard about your company’s 401(k), it might have been buried deep in the onboarding packet HR gave you in your first few days on the job.
That’s the heart of the issue with 401(k)s: they are extremely common but often complicated and unexplained.
Let’s fix that.
History of the 401(k)
The 401(k) was originally introduced in 1978 when Congress passed the Revenue Act of 1978. This act had a section called “Section 401(k)” which allowed employees to avoid being taxed on deferred compensation. Deferred compensation is a portion of an employee’s pay that is held for disbursement at a later date. According to the act, because an employee did not have constructive receipt of the money, they shouldn’t be taxed on it.
In 1980, the Johnson Companies used the Section 401(k) as a way to pay their employees more without added taxes by putting the money into a “held-away” account. In 1981, the IRS added new rules allowing employees to add money to these held-away accounts as well. This kickstarted the plan’s popularity and by 1983 almost half of all large companies were offering 401(k)s.
Today, almost every company offers a 401(k) of some sort, and yet American retirement savings are dangerously low. The retirement savings deficit is anywhere between $6.8 and $14 trillion. The typical near-retirement household has only $12,000 in retirement savings.
What exactly is a 401(k)?
A 401(k) is a “defined contribution retirement plan” and a “profit-sharing plan”. A defined contribution plan (a DC) is a plan that has agreed-upon contributions. This is separate from a defined benefit plan (a pension) that has agreed-upon payments. In a DC, an employer agrees to add money to the account while the employee is working, but doesn’t guarantee a particular value at retirement. Compare this to a pension, which guarantees a monthly payment from when the employee retires to when they pass away. Pension plans are much more expensive for companies, one of the main reasons they were so excited to adopt defined contribution plans instead.
Companies have made retiring your problem. By switching from pensions to defined contribution plans, they have avoided a massive liability and have incentivized employees to work longer.
Comparatively, 401(k)s are rather useful. They give you the freedom to switch jobs freely without compromising your retirement and are, in many ways, better suited to today’s workforce. That said, retiring comfortably is now entirely up to you.
401(k)s also help employees share in the success of their company, which is why they are called profit-sharing plans. A profit-sharing plan lets the company contribute to the accounts when there is extra money in the system. If a company has an extremely profitable year they can share the gains with all employees. A profit-sharing plan is also great for businesses because they are not required to contribute in any given year. If money is tight, the company doesn’t have to contribute anything.
As of right now, an employer can contribute either 100% of an employee’s compensation or $61,000, whichever is lower. This means an employee could get up to a 100% bonus completely tax-deferred! That is the value of a profit-sharing plan.
A 401(k) is both a defined contribution plan and a profit-sharing plan because both the employee and employer contribute. If just the employer contributes it is a profit-sharing plan, if just the employee contributes it is a “salary deferral DC”.
Let’s talk about the company match
Your company usually matches your contributions to your 401(k), so you might have been confused in the previous paragraph when I said it was entirely optional for an employer to contribute. An employer may choose to match contributions as a sweetener on the benefits package. More likely, however, your employer has implemented a safe-harbor 401(k).
If your company matches 100% of the first 3% of your salary and 50% of the next 2%, you have a safe-harbor 401(k) plan. A safe-harbor 401(k) avoids the top-heavy rules, meaning they are much easier to administer and allow key employees (like bosses and executives) to put away more money without having to make a minimum payment to lower-paid employees.
Most plans become top-heavy almost immediately because higher-paid employees can save more, so the company match is actually protecting the firm from extra paperwork.
Regardless of its purpose, the company match is free money, and it is the number one saving priority of any retirement plan.
If you have a safe harbor 401(k) you should prioritize contributing at least 5% of your salary per year. If your company has a different match (ie 50% of the first 6%) then you should make sure you are contributing enough to get the entire match.
Figuring this out can be tricky, feel free to set up a meeting with me and we’ll figure out exactly how much you should be contributing (free of charge).
Traditional or Roth 401(k)?
Now that we have established the basics on 401(k)’s we can talk about implementation. Most plans give you the option of a Traditional or a Roth 401(k). A Traditional 401(k) is pre-tax, meaning money goes in before it’s taxed, grows tax-deferred, and is taxed when you take the money out at retirement. A Roth 401(k) is post-tax, meaning money goes in after it’s taxed, grows tax-free, and comes out tax-free at retirement.
Choosing between a Roth and a Traditional is tough, so the baseline recommendation is to go with the Traditional. Choosing a Roth often comes down to knowing that you’re currently in a lower tax bracket than you will be when you retire. For instance, if your top bracket is 22% now and maybe 32% at retirement, it’s better to pay taxes now. That said, all of the money you contribute to a Roth 401(k) will be taxed at your highest marginal tax rate this year, whereas money in a Traditional 401(k) will be taxed at your lowest marginal tax rate when you retire.
Let’s do an example: George is single, age 30, and makes $170,000 per year. This means that all $19,500 that he contributes to his Roth 401(k) will be taxed at 24%. On the other hand, if he contributed to a Traditional 401(k), that same $19,500 will be taxed at 10% and 12% at retirement because it will be the first dollars he will earn rather than his last.
It’s because of this phenomenon that the Traditional 401(k) is the most reliable choice. On top of a Traditional 401(k), it’s often recommended to do a Roth IRA so you have both taxable and tax-free income at retirement. This strategy will keep you out of the higher tax brackets while still providing a comfortable retirement income.
Side note: an employer can match your contributions whether they are Roth or Traditional contributions, but the money the employer puts in the accounts is always pre-tax. This means if you use a Roth 401(k) you will end up with some post-tax and some pre-tax money in that account. This is totally fine, but you have to be aware of it, especially if you plan to do something like a backdoor Roth.
Having both a 401(k) and an IRA
The short answer is that yes, you can have both a 401(k) and an IRA, but you have to pay attention to these three rules.
If you make more than $144,000 you can’t contribute to a Roth IRA. To be safe, don’t contribute if you make more than $129,000 (this is where a weird phase-out period begins). If you’re interested anyways, consult an advisor, or the IRS.
If you have a 401(k) and make more than $68,000, you cannot deduct contributions to a traditional IRA. This means they will be taxed when they go in and taxed again when they come out. Don’t do this, do a Roth IRA instead.
If you make less than $68,000, you can contribute to both a 401(k) and an IRA (either Traditional or Roth).
Side note: there are no income limitations on a Roth 401(k), only on a Roth IRA.
To conclude
A 401(k) is an essential part of any retirement plan, especially when it involves a company match. If you’re still scratching your head about any of this, feel free to reach out. We’re here to make sure you know exactly how to use the tools available to you. We can schedule a financial check-in for free, and if you would like a fiduciary advisor to manage your 401(k) for you (because most firms leave that to you) we are happy to help with that too.
I hope you get in touch! Thanks for sticking around this long, if you mention this blog in our discovery meeting you’ll get our friends and family discount.