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One of my absolute favorite saving tools / retirement accounts is the 401k!
However, when I started working I had no idea what this account was, how it worked and why it benefited me… So today we’re going to be talking about all things 401k plans!
401k plans are an awesome investment and retirement tool you should be taking advantage of if you have the options. Let’s dive into it!
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Table of Contents
What is a 401k?
A 401(k) is an employer offered, tax advantage retirement savings plan.
Your employer directly takes money out of your paycheck and contributes it into this account on your behalf. Depending on how much you want to contribute as a percentage of your salary or a specific dollar amount.
Your employer will have a specific plan sponsor such as Vanguard, Fidelity, ADP, Empowerment etc. which you will receive important documents from. Additionally you will be logging in through their website to see your account.
This part is not connected to your employer but your employer will have guidance on how to set up your account.
Traditional 401k vs Roth 401k
A lot of people wonder how 401k is taxed. Well typically employers offer both a traditional 401k and a Roth 401k.
A Roth 401k means your contributions are AFTER tax. Income tax was paid, then the money was contributed. Then, during retirement, you won’t have to pay any taxes on ANY of that money.
On the other hand traditional 401k contributions are before tax. This is awesome because that money then becomes a tax deduction, making your income taxes go down! However, when you use that money in retirement, you have to pay the taxes.
One of the most googled questions about 401ks is “is 401k tax deductible” so yes, it is a tax deduction when it is a traditional 401k. The amount you contribute is subtracted from your gross income, then you are taxed!
TLDR
Roth / after-tax = pay taxes now, money grows and you pay zero later
Traditional / pre-tax = current taxes decrease, money grows tax free, then you pay taxes in retirement.
For a 401k I’d recommend having a traditional, pre-tax account.
There are other ways to get Roth exposure and I personally think saving money on your tax payments now, taking that saved money and investing it in a Roth IRA (blog post about this coming soon) is the best course of action.
Another money blogger, Money with Katie, has an awesome post explaining why a traditional 401k is better and I agree with what she’s saying, you can check out that post here. The key is actually investing those tax savings!
Regardless of Roth or traditional plans, 401k’s are tax advantage accounts! You’ll be saving money on taxes now or later which is awesome.
Tax Savings Math Example
Let’s take two people who make $70,000 a year salary.
| Person 1 | Person 2 | |
| Salary | $70,000 | $70,000 |
| 401k Contributions | $20,500 | $20,500 |
| Taxes Paid | $4,235 | $8,387.50 |
Now those are some juicy tax savings!
401k Match
Sometimes your employer can offer you a match amount to encourage you to participate in the plan.
A 401k match = FREE MONEY.
A 401k match is when your employer contributes money into your retirement plan, based on how much you personally are contributing.
Simply put, it is free money your employer will give you; if you meet the contributions requirements they set, for your specific plan.
401k matching contributions will vary widely from employer to employer. The most common match (according to Investopedia) is 50 cents on the dollar up to 6% of the employee’s pay.
This mean, when you contribute 6% of your pay into your 401k plan, your employer will also pay 3%.
Employer Match Math Example
Let’s say, you make $60,000 a year. Your employer match is 50% up to 6%.
If you contribute 6% of your salary or $3,600 a year, your employer will also contribute 3% or $1,800 a year.
However, if you only contribute 4%, or $2,400 a year; your employer will only contribute 2% or $1,200. That means you are losing a free $600 every year.
At the time of writing this, my personal employer match contributions equal $8,183.19. With market gains that is $8,992.94. That’s almost a FREE 9,000 dollars and all I had to do was make sure I was contributing at least 6%.
This number is from working for 3 years and hitting the matching requirements every year.
You can get free money too! Take advantage of your 401k match!
401k Vest Requirements
Ok so we just discussed how you can save money on your taxes and get FREE money from your employer, so what’s the catch?
Enter vesting requirements.
Vesting means how much of your employer match you can actually take when you leave. You could potentially lose your entire employer match if you quit before the “vesting” period.
Everything you contribute to your 401k is yours, however, employer match has a catch. (Yes free money has a catch).
There are vesting guidelines that are a part of your employer 401k plan. Typically it can take between 3 to 7 years to become fully vested, aka until you own your entire employer match.
My personal 401k plan hits 100% vested after 3 years of employment, meaning you get all your match money if you stay three years with the firm.
Some plans give you a % per year. For example, 20% after 1 year, 40% after 2 years, etc.
Make sure to know what your vesting requirements are, it might be a good thing to consider when you’re switching jobs.
401k Yearly Contribution Limit
Tax advantage accounts give you a lot of benefits by allowing you to pay less taxes, so naturally (and sadly) 401k plans have a limit on how much money you can contribute every year.
Now in 2022 the contribution is $20,500 annually. If you’re over 50 you get an additional $6,500 to contribute annually.
Setting your contribution percentage or dollar amount.
You don’t really have to worry about passing the contribution limit. Because your employer is transferring the money on your behalf, it will automatically stop contributing once you hit that limit.
However, some 401k plans employer match is considered on a per paycheck basis, meaning if you contribute up to the max in October, you’re not getting your employer match for the last two months of the year!
This of course varies depending on your personal employer plan, but it’s a safer bet to just spread out the contributions throughout the year per paycheck.
I personally get two paychecks a month for a total of 24 paychecks. $20,500 / 24 = $855 so I set my contributions to $855 per paycheck.
If you’re not allowed to write in a dollar amount, you can figure out your % contribution rate by dividing how much you want to contribute by your salary!
Investing the Money in Your 401k
We now know how much we can contribute but how do we actually make sure this money is being invested?
This part is KEY.
The last thing you want is for your 401k to not be invested!! This removed almost all advantages this retirement account has.
Make sure to login and make a selection!! OR at least double check they automatically made a selection for you.
My personal 401k plan automatically started you off on a mutual fund depending on your retirement age. Meaning I didn’t have to login and choose investments, it just threw everything into one mutual fund.
Most 401k plans will have a specific pool of options for mutual funds or etfs. You most likely will not be able to invest in individual stocks.
You will be able to set specific investing percentages and they’ll ensure your entire portfolio follows what you selected.
If you don’t know what to choose, going with a general target retirement account based on when you plan to retire is a safe bet!
Distributions – Using the Money!
Eventually, to use the money in your 401k, you have to be 59 and a half or pay a 10% penalty.
However, for those trying to retire early, there are ways to get around this penalty thanks to a tax loophole (future blog post coming about this). So don’t stress about not being able to touch that money until you’re 60.
I did think it was important to mention though because the tax loophole does take a bit of effort.
Lastly, when you turn 72, the IRA requires you to take distributions from your 401k plan. Based on your balance and life expectancy.
Aka the government wants to force you to pay taxes on this money that has been sitting there for years growing tax free.
The Other 401k Benefit – The Mental Game
The employer match is for sure the best benefit (nothing beats free money) BUT, I also like that 401k’s take money out of your paycheck directly, so you never see that money. Aka you’re not tempted to spend it because it never touched your bank account.
It is also extremely satisfying to forget about this account and then log in one day to see a nice pile of invested cash growing without you doing any work at all!
Final Thoughts
What other questions do you have about 401ks? Let me know and I’m happy to address them!
When we’re offered awesome tax advantage accounts like this, it is important to take advantage of them! When else are we going to be handed free money from our employer and be able to pay less taxes??
If you haven’t already, make sure you’re signed up to my email list, where you get unlimited access to my FREE resource library! Additionally, track your financial progress with my Ultimate Wealth Planner! This is the exact spreadsheet I use to track my finances and you can use it too!
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Thank you!
Where there is a will, there is a way.