Fundamentals: What is a 401k?

Most people have heard of a 401k, but if you’re anything like me you may not know exactly what a 401k really is.

You may know it’s something that will help you when you retire or maybe that your employer offers one for you to contribute to, but if you’re anything like I was a few years back you don’t really know much more than that.

Let's start with a definition …

According to Investopedia, A 401(k) plan is a tax-advantaged, defined-contribution retirement account offered by many employers to their employees.

What this means is that many employers offer accounts to their employees where they can invest pre-tax dollars into an investment account. This account is typically made up of mutual funds, which there are typically several to choose from depending on your plan and provider.

There are two major benefits of a 401k.

The first is that it’s tax advantaged. To break that down a bit for you, say you make $1000 a week and you want to invest %6 of your income into an investment account. If you wanted to do this on your own you would take the money your employer deposits into your checking account, multiply that by 0.06 giving you a total of $60. You would invest that money into your investment account.

The problem with this math is that employees don't see all of the $1000 they earned. You pay taxes out of each check and the remaining balance is deposited into your checking account.

Let's say your taxes total 20% of your total income (this is a modest figure). So of the $1000 earned $200 will be allocated to taxes leaving you with $800 in your checking account. Using our above example, you would then multiply that $800 by 0.06 to achieve your 6% investment goal giving you a total of $48 invested.

Investing 6% of our pre-tax dollars allows us to invest $60 out of every $1000 while investing 6% of our after-tax dollars only allows us to invest $48 out of every $1000.

This difference in pre and post-tax amounts starts to become even more substantial when our income figures become larger and when we take into account compound interest.

Let's take a look at another example …

If we make $5,000 bi-weekly and our goal remains to invest 6% of our income, or pre-tax investment would be $300 and our post-tax investment (subtracting 20% from our income for taxes) would be $240. If we invested this amount out of every paycheck (2 paychecks a month) for 20 years we would have the below results

Post-Tax Investment (considering a 7% annual return) — $236,134.04
Pre-Tax Investment (considering a 7% annual return) — $295,167.54

That is a difference of $59,033.50!

As you can see, investing pre-tax dollars can really pay off in the long run.

The second benefit an employer-sponsored 401k plan typically comes with is, employers typically match what you invest into your account up to a certain percentage of your income. Say your employer matches your contributions dollar for dollar up to six percent of your income. That would mean that the $300 you contribute out of every check would turn into $600!

One thing to keep in mind is that employers typically require you to work with them for a specific amount of time before you become fully vested, or in other words, they require you to work for them a certain amount of time before you get to keep all of those matched dollars. Each employer is different and has different time requirements. I would recommend you find out your employer’s requirements by reaching out to your HR department.

So you may be asking yourself, why doesn't everyone invest all of their money into a company-sponsored 401k. Well, there are a few caveats that come with these accounts.

One thing to remember when it comes to your 401k account is that you can not withdraw funds from it penalty-free until you are 59 and a half. While a 401k certainly is an investment account, it is important to remember it’s an investment account for retirement. If you are planning on needing the funds you are putting into this account before the age of 59 and a half there are other accounts I would recommend you invest in. If you do withdraw your funds before the age of 59 and a half there will be a 10% penalty and you will also have to pay taxes on the funds you withdraw on top of that.

The next thing to remember is that you will have to pay taxes on the funds you withdraw even after the age of 59 and a half. The rate at which you are taxed will be unique to you and your income but make sure to take into account that this taxation will be coming.

I hope this article was helpful in educating you on 401k accounts. They can play a vital role in your after retirement income, but as with most things, there are things you must take into account so you take full advantage of what they have to offer.

Talk soon,

Jarod Dickson
www.millennialecon.com

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***This article was not written by a licensed professional and the information is for entertainment purposes only.***