I admit, I’m not discussing investments from a position of experience or expertise. In fact, I would say that I know just enough to be dangerous – mostly dangerous to my family’s financial health, I suppose. But seeing as I would like to put together resources that will help me figure out a more practical way to do life, I’m going to take the risk of looking like a complete idiot and put forward some of the things I’ve been learning about how to save for retirement, specifically in my and my wife’s 401(k)s.
Honestly, I didn’t even really know what a 401(k) really was or how it worked until I started reading about them this past year. I had one available to me when I was in residency but not in fellowship, but didn’t take advantage of it because it was full of confusing terms like “vesting” and “distributions” and “contributions” and things about taxes and fees that just made me feel like it was better to avoid it altogether. Perhaps many others share that same view, or think of 401(k)s like this guy.
In regards to retirement, I had often heard that Roth IRAs were the way to go…far more often discussed than these fancy 401(k) things. In fact, even people who know far more about this sort of stuff seemed to have different views on how to best use these plans (and other plans). That definitely made the learning curve more challenging. But as I learned more about these things, the more I’ve been thinking, “yeah, this seems to be helpful.” So here are 11 basic things I learned about 401(k)s.
- 401(k) plans are a type of retirement savings plan provided by a for-profit employer; 403(b)s are the non-profit-equivalent plan.
Investopedia goes into more detail about the nuances, but I basically learned that the numbers corresponded to sections of the tax code.
- Money I put into a 401(k) plan (contributions) are pre-tax (mostly).
Apparently the government wanted to promote saving for retirement, so the portion of my salary that I designate towards the 401(k) comes directly off the top, so I don’t have to pay federal or state income tax on that money I put into the plan, effectively lowering my taxable income. Of course, Social Security and Medicare tax do not have the same sort of deduction so what is paid to Social Security and Medicare is a bit more. But since the IRS encourages legal ways to decrease tax liability, this seems like a pretty great option, especially for people in higher income tax brackets.
- I can either specifically assign (allocate) the money I contribute into specific funds, or I can go with a default option that is predetermined by either my employer or the 401(k) company.
Since I’m doing this DIY approach to investing, I’m trying the hands-on, “assigning the money myself” strategy. Hopefully it pays off.
- Investments made within a 401(k) plan grow tax-deferred.
It’s nice because buying/selling investments within a 401(k) plan doesn’t trigger capital gains taxes. Tax-deferred means that the gains are eventually taxed when the money is taken out (distribution).
- The IRS limits the amount of money I can contribute to a 401(k) every year.
The 2014 contribution limit was $17,500. The 2015 contribution limit is $18,000. For people age 50 and older, the IRS allows “catch-up” contributions which means that for those people the 2014 contribution limit was $23,000, and the 2015 contribution limit is $24,000.
- My employer may offer a “match” on my contributions up to a certain percentage of my income, which doesn’t apply to the annual 401(k) IRS contribution limit.
Bottom line, free money.
From what I understand of the matching thing, an employer may say, “ok, for every dollar you put into your 401(k), I will put in $0.50 in, up to a total of 6% of your income (50% match up to 6%).” I think that would mean that if I put contributed 12% of my income, I would get an extra amount equivalent to 6% of my income from my employer just for contributing. If I’m younger than 50 years old, this would potentially allow me to save more than the $18,000/year that the IRS allows me to contribute in 2015 (or $24,000 if I’m 50 years old or older). My wife’s 401(k) has a 100% match up to 3%, which means that her employer will match dollar-for-dollar up to 3% of her income. If we were somehow to max out her 401(k) this year, and say, for example, her income for the year was $30,000 (I chose that number to try and simplify the math), that would mean she would have a total of $18,000 + 3% x $30,000 = $18,000 + $900 = $18,900 added to her account this year.
- Once I leave a company, I can’t put any more money into that 401(k) plan…
Since 401(k)s and 403(b)s are provided by employers, I can only put money in while I am employed at that company. Seems straightforward enough.
- …but the money is still mine. All mine.
There’s this tricky thing called vesting that may affect any matching contributions from my employer, but all money I’ve put in out of my paycheck and the growth on that money is mine. (I’m quite proud of my three prepositions in a row).
- If I leave the money in that 401(k) plan after I leave that job, I will be responsible for all the fees on the account.
My employer pays the 401(k) administrative fees to some degree while I work there. Apparently they don’t like paying those fees for non-employees. Sad.
- I can initiate a rollover to move all of the money from the 401(k) plan into my present job’s 401(k) or to a traditional IRA.
I think there are forms to fill out and some magic financial voodoo happens, but if done correctly the money can get moved over without any penalties.
- I can take out a “loan” from my 401(k) up to 50% of the current balance or $50,000, whichever is lower, and pay it back with “interest.”
I don’t think I’ll ever do this, and quite a few financial people are against borrowing from a 401(k), but basically the idea is that I’m borrowing money from my future to pay for something now, and to make it up I would pay it back to myself at a fixed interest rate amortized over 5 years. As long as I adhere to the terms of the loan, this money is not taxed. Since I’m borrowing from myself, I’m essentially paying myself back for the lost investment time. So some people have suggested doing this for things like a down payment for a house mortgage.
Of course, if I’m having to work extra (or earn less) during the time I’m paying that loan back and I’m not able to contribute to the 401(k) like I was before, I’m still going to be behind financially. The “interest” payments I make are with after-tax money, so I don’t get to deduct any of that extra money from taxes (but it will get taxed when I withdraw it for real – basically meaning that it’s double-taxed). Also, if I quit or lose my job while I’m still trying to pay off that loan and I’m younger than 59 1/2, I am required to pay back the full balance of the 401(k) loan within 2 months, or else the outstanding balance is counted as an early distribution and gets added to my ordinary income for income tax, PLUS an extra 10% tax penalty on that outstanding balance. Seems pretty risky to me.
Here’s an article about 401(k) loans from Forbes.com.
Now, after learning about all of these things about my 401(k), I’ve decided I should probably go ahead and start put some money in. Of course, deciding is just the first step – I had to learn how to set up the account, how to put money into the account, and then figure out what to do with these “funds” available in the account. More on that next.