What is a 401k? Should you invest in one?
401k… we hear this term thrown around at employee orientation and all throughout our working lives but what is it exactly? More importantly, should you invest your hard earned money in one? For starters, a 401k is a defined contribution plan that is sponsored by your employer. In English, a 401k is a retirement savings account, in which you can stash away pre-taxed dollars and invest them to grow on a tax deferred basis. The name comes from the section of the Tax code that governs them (section 401). I should note that not all 401k plans are the same. These plans vary from employer to employer and not all employers offer 401k plans for their employees. Now that we know what 401k’s are, lets discuss some advantages and disadvantages of these retirement plans.
401k’s allows you to save pretax dollars and invest them on a tax deferred basis (up to a max limit). When you elect to enroll in your companies 401k plan you are allowed to choose a percentage of your income that you want to contribute to the plan on a weekly or bi-weekly basis (depending on how you are paid). The plan then deducts this money from your check before it is taxed and puts the money in the account. The money is then invested for you and grows tax free. You are only taxed when you take distributions from the plan during retirement (note that there are penalties to taking out money prior to retirement age 59 ½).
Some employers match your contributions, in other words, GIVE YOU FREE MONEY. Employers typically match a percentage of your contribution up to a max amount. For example, my prior employer match 50% of our contribution up to 6% of our income. Over time this can accumulate to hundreds of thousands of dollars in free money. I always advise my clients to invest in their 401k up to the match.
Its automated! One of my best tips for saving is automation. The money is taken out before you get your check so you don’t really notice that the money is gone. After a while you completely forget that you are saving hundreds or even thousands of dollars a month.
Creditor Protection. 401k have top notch credit protection. Even if you file for bankruptcy creditors cannot get to this money. The only organization I know that can touch this money without your approval is the IRS.
Some 401k plans offer loans. I don’t often recommend taking a loan from your 401k unless you have no other choice but the fact that you have an option is great. Keep in mind not all plans offer this option.
Limited investment types. 401k plans have limited investment options usually restricted to stocks, bonds, and mutual funds. On top of the limited investment types, they may also have poor investment options. Some 401k plans only have investment option with high fees. If this is the case you should go to your employer and request low fee investment options. They have a legal requirement from the Department of Labor to have good quality investment options in their 401k plans
Money is captive. As mentioned before, if you take money out of this plan prior to age 59 ½ (with some exceptions) not only will you be taxed but you will also have to pay a 10% penalty as well.
Administrative cost. 401k plans have admin cost that can be passed down to the employees. Some employers pay this fee but not all. Smaller companies can have 401k admin expenses up to 1.5% yearly which over time can really cut into your retirement savings.
Now that we’ve discussed the advantages and disadvantages of 401k plans, should you invest in one? And if yes, how much? The answer to this question is… it depends. I know you hate hearing this answer but we must consider other variables. It depends on the employer’s plan, if they provide a match, what financial state you are in, etc. With all that being said, I usually always recommend investing in your companies 401k plan up to the match that they provide. This is free money and essentially represents an infinite return on your investment. However, if your employer doesn’t offer a match there are still benefits in investing some of your money in their plan but only after maxing out other retirement accounts.
All in all, 401k plans offer a great way to save pre-tax dollars and invest on a tax deferred basis. I personally try to max out my 401k every year but only when I max out all of my other tax advantaged savings vehicles. I hope this discussion gave you more insight on 401k plans and please subscribe for more content!