Rajesh Kumar

Optimizing life, one day after the other

401(k) Demystified

28 May 2017

I first came across the concept of 401(k) back in 2009 when the company I was interning at the time setup a 401(k) policy for its employees. They might've even made a contribution match which is rare for private companies here in the Bay Area. As an intern however, I wasn't eligible for the 401(k) benefit so I basically ignored it. 8 years later, I finally feel like I have somewhat of a grasp on this beast of a benefit. It's taken me 3 months of reading to fully understand all the nuances of the 401(k) plan/program and the rules surrounding it. Unfortunately, there's no one single place you can go read to figure everything out — I had to read 15+ articles, each one shedding light on a new area, but still a lot of overlap in info between them. So I'm dumping my knowledge and understanding thus far here so I can have a single place to go to answer 95% of my (or your) 401(k) related questions.

In the past, every time I feel like I've understood the 401(k) plan/program, I was proven wrong by coming across something new in my readings. As of the last couple weeks, I haven't come across anything new in my readings so I'm assuming I'm getting close to covering the space (~90%). But it's still likely I'll be learning new things over time. If I do, I'll add them to bottom of this post.

Disclaimer: Use these notes merely as a guideline, don't make actual financial decisions on them without consulting someone who actually does this for a living, i.e. a tax professional. This information is just a summary of the many 401(k) related blog posts I've read over the past few months — there is no guarantee of any factual accuracy. It's not like I actually pored over the IRS tax code. Moreover, the rules could've changed since those blog posts I read were written or since this post you're reading was written, so you always need to look up the latest rules/policies for the current year.

So here we go:

  1. Pensions: In the past, there were pension programs sponsored by your employer to cover you during your retirement years. This was back when it was common for employees to work with one single employer for a really long time, often until retirement. These pensions would be funded by the employer by taking a slice of your paycheck and investing it into the market (or the company) on your behalf. When you grew old, the employer would pay you the interest and dividends on this accumulated investment to fund your retirement.

  2. 401(k): As people shortened their stay with employers, the pension strategy became difficult to administer across employers. People also started living longer, so the company was responsible for larger and larger amounts since the pool of retirees was now constantly growing. Furthermore, companies now had to bear market risk. Whenever the market was down or there was a recession, the company would be strained to make its fixed payments to all its retirees. Ideally the US govt. would've taken on this responsibility, but they didn't. The US govt. does Social Security but I don't think its enough to fund your retirement, maybe just to supplement it. In light of all this, the responsibility (burden perhaps?) of funding your retirement was shifted from the employer to the employee (i.e. you). Thus was born the 401(k).

  3. Contributions: Contributions to your 401(k) plan are made via your employer's program. These are pre-tax paycheck deductions made automatically by your employer on each paycheck. The good news is that you never see this money in your checking account so you can't accidentally spend it. The plan is usually administered by your HR department, but they do it via a plan manager such as Fidelity, Vanguard, Ubiquity, etc.

  4. Tax Savings: The 401(k) is an amazing program if used wisely, but you really need to know what you're doing. The govt. wants to incentivize retirement planning and so to do this it makes the money contributed there entirely tax-deferred (not tax-free) at both the Federal and State levels. If you earn more than $40-$50k/yr and are therefore in the higher tax brackets (25%+), the savings are from your marginal tax rate which is the highest tax rate your income suffers each year. This is a big deal.

    In retirement (i.e. no regular work income), your marginal bracket is expected to be lower since you'll be withdrawing a smaller amount than the money you make now. The retirement withdrawals are taxed at the average tax rate, which is assuredly lower than you marginal tax rate both now and then. Also, if you don't live in the country during retirement or move to one of the special states, you may not even need to pay state taxes then. Whatever tax delta you have between your working years and retirement, you get to keep for yourself. Overall, huge financial savings for most normal people.

  5. Starting Early: Sadly, you have to manually opt into this program and many people don't opt-in for a really long time, often for several years after they begin working. The sooner you start maxing out your contributions, the larger your tax savings over your lifetime. But more importantly, you also see bigger returns and growth of your money over time due to the powerful exponential properties of compound interest. Also, you can't make up for missed contributions, so once a year has passed, you can't ever take back that tax money from the IRS.

  6. Contribution Limits: The contribution limit is $18k this year, but it keeps increasing almost every year to account for inflation. Why have a contribution limit? Because the govt. wants to cap the amount of tax savings one can enjoy. The contribution limit might also be lowered depending on certain company situations such as how many other employees are contributing and how much, etc. The catch-up contribution limits for people aged 50+ are $6k higher (as of 2017), so $24k/year.

  7. Matching: Some companies want to encourage their employees to invest for their futures and will therefore match whatever the employee contributes to his/her 401(k) account, up to a specified maximum. This maximum can either be a fixed amount like $5k, or a percentage of the employee's base salary, say 5% for example. The matched portion isn't counted towards your $18k annual limit. When you compare job offers between prospective companies, you need to take this match into account.

    It seems common for people to think that if there's no match from the company, then there's no sense in contributing to one's 401(k). This couldn't be further from the truth. Certainly if there's a match, you should definitely be taking full advantage of it by contributing at least up to the amount of the match. However, the biggest win of the 401(k) is deferring taxes on earned income now (and that too at the marginal rate) and then hopefully having to pay significantly lower taxes on the same money later in retirement. This can happen with or without a match. The downside is that you can't easily touch that money until you turn 59.5. But who cares? You want some portion of your money to be untouched until you're that old anyways. Why not make that portion live inside your 401(k)?

  8. Savings Boost: Because housing and taxes are often the biggest expenses for most working people, it's important to find ways to save money by reducing your tax expenses every year (legally of course). The 401(k) plan is by far the easiest government-approved way to do this. If you make $110k/yr for example, you instantly save ~28% of $18k in federal taxes alone (in addition to state taxes), which is an extra $5k of savings every year. Compound that annually over 20 years at an 8% annual growth rate (conservative), and that's easily ~$230k before taxes. That calculation doesn't even take into account the inflation-adjustments to the $18k annual limit, and the extra catch-up contributions when you turn 50. If you're relatively frugal and have a paid-off house, you may get away with a 10-15% average tax rate which is still a neat $200k extra for no additional work. The extra $230k savings in your account is an additional $9k in free money every year in retirement using the 4% rule. The math is even better if you work longer, say for 30 or 40 years.

  9. Front Loading: Some people (like me) prefer to front-load all of our 401(k). This means trying to max out your $18k contributions as early as possible into the year rather than spreading the $18k evenly throughout the calendar year. There's many good arguments for doing this, and very few good ones against it. For me, the main reason is to make sure I don't give myself a chance to stop/pause the paycheck deductions for whatever reason as the year progresses and then forget to resume them before it's too late. Maxing out your 401(k) every year guarantees a bare minimum savings amount of $18k/yr. This turns into a savings bucket of a million dollars if you work for just 22 years.

  10. Marriage: If your spouse has his/her own 401(k) plan, then all the benefits of 401(k) are 2x. There's no reduction/increase in benefits when you get married or have kids, etc.

  11. Rollovers: Once you quit your company, you can leave your money behind in the same account, or roll it over into your next company's account. You're not required to rollover, so you would only do that if the next company's investment choices are better, or if you just want to simplify your life by having fewer accounts. Alternatively, you can rollover your money to an IRA (independent retirement account) which gives you virtually infinite freedom in investment choices depending on who you hold your IRA account with. Rollovers are not a taxable event.

  12. Tax Sheltering: You can do any amount of trading inside your 401(k) among the choices of investments your company provides without triggering a taxable event. Ergo, you don't have to worry about capital gains tax or ordinary income taxes at that point. Dividends are also tax-deferred so the money just keeps growing forever without any tax friction. In contrast, trades made inside a taxable brokerage account are all taxable events. Non-qualified dividends are taxed at the ordinary income rates as well. The 401(k) is therefore a tax shelter which means you don't have to think about any taxes until you pull your money out.

  13. Withdrawals: The only catch to a 401(k) plan is that you can't make withdrawals until you turn 59.5 years of age. If you withdraw any sooner, you pay the tax on it as well as a steep 10% penalty on top of the taxes. The 10% penalty exists to act as a deterrent to pulling out your money before retirement for silly purchases such as a TV/car/jacuzzi/etc. However, you can take a loan against your 401(k) penalty-free for your first home down payment or if you suffer from financial hardship. But that's generally a bad idea since you can't make up for the lost contributions made in previous years.

  14. Sharks Beware: The truth of the matter is that everyone wants your retirement money. Everyone wants to skim off a portion of your income growth in the form of fees. Whichever company your plan goes with for administration will tempt you to invest your money in their mutual funds which will have insanely high fees every single month. What's worse is that these fees aren't fixed, they are a percentage of your entire portfolio!

    The only way to curtail these sharks is to pick your investments really really carefully. If you're lucky, your company will offer a few super low-cost index funds (i.e. less than 0.1% in fees every year). That's where you want your money. Make sure you sort all your 20-30 choices by fees (also known as Expense Ratio) and look towards the bottom of the list for the low-cost index funds. Your weighted annual fees across your entire 401(k) portfolio should ideally not exceed 0.5%.

    Choices offered by my 401(k) provider (Fidelity) sorted in descending order of expense ratios (i.e. fees). Look to invest in the low-cost index funds towards the bottom of the list.

    So many people are currently getting screwed by this as we speak since people have no idea they're being charged all these fees quietly in the background. Mutual funds have a sneaky way of grabbing a good chunk of your investment returns in the form of hidden management fees, and that too usually for sub-par performance compared to unmanaged index funds. Index funds are not actively managed and are therefore not usually subjected to the inordinately high fees as mutual funds often are.

    More reading on this topic here and here. This problem is so ubiquitous in America now that there's an entire documentary dedicated to this too!

  15. Early Withdrawals: What if we want to retire before the age of 59.5? One non-ideal option is to just suck it up pay the 10% penalty which might still save you lots of taxes if your income bracket during your working years was sufficiently high and you retirement income is sufficiently low. But the govt. provides 2 legal ways of pulling out the money without penalty which we'll cover below. More detailed reading on this topic here and here.

  16. Roth Conversions: This is the first technique. In this strategy, you first roll over all your 401(k) money into an IRA once you quit your job. Then you pull out a small amount of money each year from this IRA, say $40k, pay the pitiable 10-15% average tax rate on that money (totally reasonable rate IMHO in this country), and transfer that money over to a Roth IRA. This transfer is a taxable event but without penalty. You then have to let the money sit in your Roth IRA for 5 years minimum and pull it all out at once (principal only) without further taxation. You then do this every single year until you turn 54.5. Once you hit 59.5, you can just withdraw money normally (and penalty free) without any Roth conversions. Also when you hit 59.5, you can withdraw all your Roth IRA growth at once, tax-free and penalty-free.

    So say you paid 15% taxes on the $40k during the Roth conversion, you get to use $34k each year without penalty. You just have to figure something out for the first 5-years of this plan — maybe have enough cash saved up for those years before you retire.

    More detailed reading on this topic here.

  17. SEPP: Substantially Equal Periodic Payments (aka SEPP aka Rule 72(t)) allows you to withdraw a certain small percentage (~3%) of your retirement money early without penalty, but with normal taxes. The catch however is that you have to do it every single year until you turn 59.5. If you don't, you face steep penalties!

    More detailed reading on this topic here.

  18. RMDs: RMDs are required minimum distributions. This means you can't keep the money in your 401(k) forever. At some point, the govt. requires you to start taking that money out slowly and pay the taxes you once deferred on it. At the time of writing, the RMDs start at age 70.5, only 10 years after penalty-free withdrawals kick in. If you don't take the required money out then, you'll be faced with yet some more steep penalties. More detailed reading on RMDs here.

  19. Death: What happens to your 401(k) account when you die? I don't know yet. I haven't looked into it. Presumably your living spouse inherits it. What if he/she isn't alive either? Presumably your kids get it. Do they need to pay taxes or penalties since they're likely not 59.5 yet? Not sure. If I look into this, I'll update here.

  20. Roth 401(k): Some companies offer a Roth version of the 401(k) which is a post-tax investment account. You make contributions with your after-tax money, but all of the growth can be extracted tax-free once you reach the age of 59.5. Your principal is always withdrawable without penalty anytime but this makes the Roth 401(k) dangerous. It's all too easy for most people to withdraw money from their Roth 401(k) for sudden emergencies and purchases, whereas with a traditional 401(k), the 10% early-withdrawal penalty motivates most people to not touch that money until retirement.

    Most people don't (and shouldn't) do Roth, but there's a few good reasons to contribute to a Roth 401(k):

    1. You're early in your career and your marginal tax bracket is low (i.e. <=15%). If you foresee your salary increasing dramatically over time (as is the case with experience-based professions), it's better to pay the lower tax-rate now and then switch to a Traditional 401(k) later in life when your marginal rate increases to 20%+.

    2. You foresee yourself having so much money in retirement that you think you're likely to live a more luxurious life in retirement than you would be during your working years. This is usually not the case but might be true for some people.

    3. You expect tax rates to increase above and beyond the regular inflation-rate during your retirement years.

    4. You are unsure about the tax laws over the large time horizon and fear the government might change them on you sometime in the future. You want to use the Roth to "diversify" your retirement funds.

    5. You think you'll want to withdraw all or a large chunk of your money immediately after hitting 59.5. With a regular 401(k) account, you would owe a huge tax bill if you pulled out all your money at once. With Roth 401(k), you would owe nothing.

    6. You're primarily investing for your heirs rather than yourself. In this scenario, you may not want to burden your children with a tax bill on withdrawal. Note: I am not intimately familiar with the tax implications of a Traditional 401(k) account upon your death.

In summary, the 401(k) is one of the most powerful vehicles available to regular working people to postpone and reduce their annual income taxes, thereby increasing their savings rate. You can either give a portion of your earned income this year to the IRS, or you could give it to your future self at age 59.5. You choose.

Maxing out your 401(k) plan every single year could easily allow you to retire an entire decade ahead of schedule depending on how much you make. It also guarantees a minimum decent amount of untouchable savings per year, something we could all benefit from massively in the long run.

« Smart FrugalitySustainable Indulgence »

[ about | all posts | subscribe | resume | contact ]