Employer Benefits 101: 401(k) Plans

Listen — I’m totally aware that there are approximately 1 billion articles about 401(k) plans. I also know there are another 2 billion that revolve around this super fun debate a lot of employed people like to engage in around Traditional versus Roth 401(k)s; however, I still think this topic is important to cover, as evidenced by the number of DMs I’ve received about this particular retirement savings account.

Okay, FINE. My DMs weren’t my only motivation.

I made a seriously embarrassing 401(k) mistake at the start of my career that I’m hesitant, yet willing, to share with the hope that it will help you avoid making the same bone-headed error. Let’s go!

What is a 401(k)?

A 401(k) is a savings account provided by your employer to help you save for retirement. Fun fact: This savings account was very “creatively” named after its own section of the tax code!

*If you’re self employed there is a solo 401(k) option, but as a quick little disclaimer, this article will focus primarily on employer sponsored plans.

Key things to know about 401(k) plans, in general:

• There are two types - Traditional and Roth

• There are maximum contribution limits that change frequently.

• Employers sometimes match a portion of your contributions.

• You get to choose where your contributed funds are invested based on plan options.

• There are rules around when you can, cannot, and are required to withdraw the contributed funds.

Types of 401(k)s

There are two types - Traditional and Roth. What’s the primary difference between the two? When you pay taxes on the money in the account.

• Traditional 401(k) - You pay taxes when you withdraw the funds from the account during retirement.

• Roth 401(k) - You pay taxes today, and you withdraw the funds during retirement tax free.

Making the determination of which 401(k) to select involves some educated guessing (and math, if you’re feeling frisky.) It could also be dependent on your employer - not all of them offer a Roth option. Today we’re focused on learning the conceptual differences so that you can do the math with your real dollars.

One way to make this determination is to figure out the time in your life when your tax rate will be lowest — that’s when you’ll want to pay taxes on the contributed funds. (Hint: Tax rates are based on income, so compare your income now to your projected “income” in retirement. Here’s where the educated guessing comes in, since we don’t know what tax rates or your necessary retirement income will be in the future.)

I bet you’re thinking, “Maggie, when I’m retired I’m not going to have an income, because I’m…retired.” Eh, not exactly. You receive a constant stream of income while you’re young, spry, and working, and it’s prudent to tuck some of that away for when you’re old, gray, and unable or unwilling to work. Those saved dollars will fund your retirement “paychecks.”

Most people don’t retire and withdraw all the saved money in one lump sum and store wads of cash under their mattresses for the next 20-40 ish years. That would be really stupid for a lot of reasons, which is why most retirees withdraw a consistent amount of money from their pool of saved dollars every month to mimic an employer paycheck. This is why everyone tells you to save money TODAY, if possible. You want a decent sized pool to draw from one day.

Let’s bring this analysis to life.

We’ll say you’re 30, married, and make $100,000 annually. Your effective tax rate today is 22%. If you choose a Traditional 401(k), you’d get to deduct the contributions from your taxable income today (whoohoo!), and you’ll pay taxes on the money later when you withdraw it during retirement (boooo).

If you choose a Roth 401(k), you’d pay taxes on your contributions today (boooo) at a rate of 22%, and you’ll withdraw the funds without paying any additional taxes later (woohoo!).

• Generally speaking, if you think you’re going to have enough money saved to maintain a higher retirement salary that falls within the next tax bracket, you may want to choose a Roth 401(k) so you pay taxes within the lower 22% bracket today instead of within the higher 24%, 32%, 35%, or 37% brackets in the future.

I personally have a Traditional 401(k), because I suspect that the tax bracket I’m in today (and within the next few decades) will be higher than my tax bracket in retirement, even if tax rates increase a bit. I personally think our lifestyle and immediate, future life phases will involve us making and spending more money than in our “gray years.” The next decade or two will likely hold children, a larger home purchase due to said children, their medical bills, extracurriculars, larger grocery bills, education costs, etc. Once they’re grown, our annual spend will probably decrease, even with an increase in medical bills, since we’ll just be providing for two people again. That means we can likely withdraw and live off a lower annual salary in the future.

I will say, one of the most compelling arguments for using a Roth 401(k) has to do with those same hypothetical children. Recently, laws were put into place that require people who inherit 401(k)s to withdraw all the funds within 10 years of inheriting them. That means that if something happens to Bryan or me when our hypothetical kiddos are, let’s say, 45, they’re likely to be in the highest tax bracket of their working years if they follow a traditional career path. Poor things will have to pay a boat load of taxes on the money they’re required to withdraw from the Traditional 401(k) over the next 10 years. If we leave them with a Roth 401(k) instead, they’d get to pocket the withdrawals with no tax implications whatsoever. (One could argue that leaving them anything is a gift, and if they have to pay taxes so be it!)

There are a ton of assumptions in that one paragraph, though — mine and Bryan’s expiration dates, my future kids’ existence, their hypothetical career paths, tax brackets of the future, a healthy remaining 401(k) balance after we live out our days as retired folks, etc. Do you see where I’m going with this? It’s hard to tell the future, but that’s a compelling argument for the Roth if those rather reasonable “what ifs” come to fruition.

Everyone’s situation is different, and since I can’t tell the future, I have no idea how much life will cost and how much Bryan and I will collectively make over the next 20 some-odd years. However, since my immediate future is more predictable than the far off future, that’s my logical justification for choosing the Traditional over the Roth. If you’re looking for a more mathematical approach to deciding between the two, Money with Katie has a great one.

Bottom line: It’s really hard to guess how much you’ll be making in the future and what the tax brackets during your retirement are going to be. You just have to do your best with the facts available to you today.

Maximum Contribution Limits

If you’re reading this article and feeling a sudden urge to aggressively save for retirement, I applaud you, but you may need to find several ways in which to do so. The maximum amount of money you can contribute to your 401(k) each year changes frequently. The IRS really knows how to keep things spicy!

If you’re under 50 years old in 2022, you’re allowed to contribute up to $20,500 in pre-tax dollars. Over 50? You can contribute up to $27,000. Here’s the catch: you can’t contribute lump sums of money at any given time like you can with a brokerage account. Instead, you have to contribute a percentage of each paycheck to the account without exceeding that annual contribution limit. Otherwise, you have to pay penalties.

Some advice I received a few years ago that really stuck with me was, “If the IRS is putting a limit on it, it must be good.” And I agree! If you are able to contribute the maximum, I would encourage you to do so.

To get a rough estimate of the percentage of each paycheck you should contribute to meet the maximum, take the annual allowable contribution, and divide it by your annual salary:

Using the example above: $20,500 (max limit) / $100,000 (gross annual salary) = 20.5% per paycheck

Things to keep an eye on after you’ve selected the percentage contribution amount:

1) Cut-off features: My employer (and potentially yours, too) offers a feature that cuts off pre-tax contributions once the limit has been met to help employees avoid penalties. Big win! Some plans may not offer this “cut off” feature, and you can confirm whether or not that’s the case by diving into the plan details your employer provides or contacting the plan administrator.

2) Planned changes in income: If you receive an annual raise, the amount being contributed to your 401(k) will increase proportionately with that raise. For example, my employer has a fiscal year that differs from the calendar (aka, tax) year. At the start of each fiscal year (July), I receive a raise that increases the amount of money in my paycheck, and by extension, the amount I’m contributing to my 401(k). That typically helps cover any potential under estimations, but it could also make me accidentally over contribute, if I didn’t have that fancy “cut-off” feature.

3) Unexpected changes in income: If you lose your job or if you receive some sort of unexpected spot bonus, it’ll change how much is being contributed to your 401(k), since contributions are based on a percentage of your paycheck. For example, I am awarded an annual bonus each fall, and while the amount changes every year, I have 7 years of historical data to prove that I’ll see some sort of spike in one of my fall paychecks that will contribute some extra dollars to my 401(k). Moral of the story: Keep tabs on your contributions throughout the year.

It’s better to overestimate your contribution percentage than to underestimate it, since you can’t make any “catch up” contributions (unless you’re over 50.) The one thing you can do, if your goal is to max out your 401(k) and your contributions are trending low, is raise the contribution percentage for a few months if your employer allows you to do so at will. Just remember to decrease the percentage timely if you don’t have an automatic contribution limit cut-off!

Employer Match

As an incentive for employees to contribute to a 401(k), some employers offer to contribute a small percentage of cash in addition to what you’re putting into your account. This generous contribution is known as an employer match.

Let’s say your employer matches 25% of the first 6% of your contributions each pay period. In our prior example, you chose to contribute 20.5% of each paycheck to your 401(k). Let’s say each paycheck is around $3,800.

$3,800 * 20.5% = $779 would be your contribution per paycheck

$3,800 * 6% = $228 * 25% = $57 would be your employer’s contribution per paycheck

If your employer offers a match, it’s worthwhile to contribute AT LEAST the percentage that they’re willing to match in order to take full advantage of the benefit. Otherwise, you’re throwing away free money. Also, your employer’s matching contribution doesn’t count toward your annual contribution limit - they have a separate limit.

When I first started work, I didn’t make enough to max out my 401(k) comfortably, so I started by contributing the percentage that my employer matched and then upped my contribution percentage by at least 1 to 2 percentage points each year I received a raise.

Where to Invest Your Funds & an Embarrassing History Lesson

Remember in the Health Insurance Plan post when I mentioned that I was completely overwhelmed by all of the employer benefit options I was required to select? The 401(k) plan situation definitely contributed to that stress. At the time I started my career, I had no personal investments to my name, and I knew approximately nothing about investing in general.

This is super embarrassing to admit, and I considered omitting this from the article altogether, but I think this admission will help MANY of you not make the same mistake that I did. I (can’t believe I’m telling you this) chose to invest 100% of my 401(k) contributions in cash. It was legitimately the only fund I understood of all my options at the time, and instead of doing research or consulting with my parents, I panic-selected CASH and never looked back until a few years later. Yes - I said years.

Why is this tragic and embarrassing? I gave up years of beautiful market returns because I didn’t take the time to invest the dollars properly. I was doing the electronic equivalent of storing money under my mattress. Was I still saving? Yes. Was my account still growing? Yes. Things could have been worse, but they definitely could have been a LOT better.

I’m not here to offer specific investment advice, just to share with you what I perceived as a personal mistake. I ultimately ended up investing the balance of prior and future contributions in the S&P 500. Had I made no elections at all and been assigned the default investment plan, it would have invested the contributions in a Target Date fund based on my birth year—another great option. Do the research! You’ll thank yourself later.

*Keep in mind, your investment options are limited by your employer’s plan offerings. Pay special attention to the administrative fees associated with your selection, too. These fees are usually presented as percentages —0.01, for example — and talked about in terms of “basis points” — 0.01 = 100 basis points. The lower the better!

Withdrawing the Funds

So you’ve funneled cash into your 401(k) for years, and you’re sitting pretty. You’re thinking about buying a house, and you need a little extra cash for your down payment. Unless you’re 59.5, STOP!

The money in your 401(k) can’t be withdrawn without incurring fees/penalties until you’re almost 60 years old. If you’re contributing to a 401(k), you’re playing the long game. Remember that this account, along with others like a Roth IRA or Traditional IRA, is meant to serve as the future pool of money for your retirement “paychecks,” not the downpayment for your house in your 30s.

There are some people who think that maxing out a 401(k) isn’t a good idea for this exact reason. My take on the matter is this: Personal finance is personal. There isn’t a one size fits all approach to any concept, because we all have different jobs, expenses, wants, needs, etc.

If you can’t max out your 401(k) comfortably, don’t! It took me years and several pay increases before I felt comfortable doing so. If you are willing and able to max out your 401(k), you should then consider where you should save the $20,500.

• You could put all of that into your 401(k) if you don’t have any short-term needs for the saved dollars.

• If you do have a large purchase on the horizon, play around with how you want to save the total $20,500. Consider putting at least enough in your 401(k) to get the benefit of your employer match, if available. What you do with the rest is up to you. Putting some of that $20,500 into a brokerage account instead of going all in on your 401(k) would allow you to still save, invest, and grow funds that are a lot more easily liquidated for your short term needs. The amount you contribute to your 401(k) will be waiting for you once you retire.

Action Items

Reassess your contributions - If it’s been a few years since you assessed your 401(k) contribution percentage, log into your account and take a look. Maybe you have a little wiggle room to increase your contributions because you’ve gotten a recent raise. If you weren’t contributing anything because you thought contributing to a 401(k) was an all-or-nothing game, it’s not. Every little bit counts toward saving for retirement.

Check your investments - Did you accidentally invest your contributions in cash during your first week at work, too? Don’t sweat it. There’s still time to make a change! If you’re young, consider investing in a more aggressive index or selecting a target date fund, since you’re playing the long time. If you’re approaching retirement, consider a more conservative investment approach in this crazy market we’re in.

Don’t forget to live — A great piece of advice I’ve been given over the last few years is to save diligently and do what you can to set your future self and/or future family up for success, but don’t forget to live today. We don’t know how long we have on this earth, and saving, saving, saving, and sacrificing everything while you’re young may allow you to retire early, but it could make you miss out on a lot of today, too.

Happy saving!