The Investment Series Part One: What the Hell is a 401(k)

While it can be really exciting to talk about Financial Independence and the freedoms that you are buying yourself, the truth is that the journey takes some very simple but hard decisions to get you there. While some people can continue to dream that they are going to hit the lottery, start a business that they sell for millions, are inherit money from a long-lost aunt, you and I are going to become rich the low and slow way. Saving and Investing. After talking about how to budget to know what you are spending, you should have cut back on your spending and have some money to start putting away. But the next question is obvious: Where do I put it? This is a VERY loaded question, one that can get VERY different answers from financial experts. My best way to give a straight answer is that it really depends on your financial situation, what your goals are, and when you plan to retire. My goal with this article is to just lay out all of your options and give you the pros and cons of each.

Overview

While many people have hear of this, and hopefully all of you are participating in one if your employer offers one, I’ve noticed that many people just “do what HR tells me”. This is THE best investment tool to take advantage of if you work for an employer that offers one. The biggest and best reason to contribute to your 401(k) is because it is a pre-tax contribution. This means that your employer will put the money into your retirement account before Uncle Sam ever gets to take a swipe at your paycheck. Not only does this mean that your contributions can be larger (since they are before taxes), but it lowers your taxable income, and in turn, your taxable liability at the end of the year. In addition to going in to the account tax free, it gets to grow tax free as well. So as you have it invested (hopefully in index funds or a target date retirement fund), it will grow and grow without having to be taxed. This means that all of those dollars that you normally spend on your tax in your paycheck are working for you to increase the amount you get back as a return. Then, when you’re retired and ready to tap into this account, you will be taxed at your income tax rate (which will depend on how much money you take out in that year).

Limits

As of 2017, you can contribute up to $18,000 per person, per year, tax-deferred. So that means if you’re married filing jointly, you can put in $36,000 pre-tax. If you are over the age of 50, the government wants to help you save more with a “catch-up” contribution increase by giving you an additional $6,000 in pre-tax contributions. So if you are over 50, you can put in $24,000 if you’re single, $48,000 if you’re married and both over 50. It is important to note that it might be possible to still contribute to your 401(k) after this limit (refer to the section below After Tax Contributions). What else can boost your contributions?

Employer Match

It is very common for employers to offer up some sort of “match” to your contribution. You should check with your employer as to what their policy is. While it can be hard to start saving for retirement, you should at least contribute enough to max out your employer’s matching policy. This is as close as it gets to “free money” in this life. It is also important to note that the employer match does not affect your $18,000 pre-tax limit. That amount is based only on YOUR contribution. Anything your employer matches is just a bonus.

Now for an example: Let’s say that I make $50,000 a year and my employer matches 50% of my contributions up to 6% of my salary. Even if it is hard for me to invest in my 401(k) right now (whether I am cash strapped, paying down debt, whatever), I need to at least be contributing 6% to max out the match.

$50,000 X 6% = $3,000 of my contribution

$3,000 X 50% = $1,500 employer match (AKA free money)

The employer match can start to add up substantially after a few years. In addition, the best thing you can do is invest heavy as young as you can, because compound interest will be your best friend. While it may not seem like much in the beginning, that match can grow to tens and tens of thousands after 40 years of building.

After Tax Contributions

So we covered that you can only contribute pre-tax dollars into your 401(k) up to $18,000 and that your employer can add their own percentage in as well, but is that all you can do with a 401(k)? Well it depends on your company’s and the administrator of the plan. Certain companies will allow you to make post-tax contributions to your account, up to a total amount of $54,000 in total contributions for 2017 (however, if you’re over 50 then you get your additional $6,000 in catch-up contributions, bring your total to $60,000). This amount includes the pre-tax contributions that you made and your employer’s match.

So for an example, let’s say that I maxed out my pre-tax savings and my employer made a match of $4,000.

$18,000 = Pre-tax Contributions

$ 6,000 = Employer Contribution

$30,000 = Possible Post-Tax Contributions

$54,000 = Total 401(k) Limit

What is the benefit of contributing to your 401(k) with post-tax dollars? The plan will split your contributions into two silos: One that has pre-tax dollars (that you will have to pay tax on when you pull it out) and one that has post-tax dollars (that you have already been taxed on). The good news is that no matter what type of dollar it is, you can defer paying any tax on the gains they make until you pull it out in retirement.

But then why do people contribute to IRAs after they max out their pre-tax contributions? This is where it starts to depend on your individual plan and what your plans are for after retirement.

Possible Cons

While I fully encourage everyone to at least participate in their 401(k) to get the max employer match, after that it will depend on the plan that their employer offers. While the best thing that you can get is some sort of index fund or target date retirement fund through Vanguard or Fidelity, the reality is that not everyone has that option. See, with the 401(k)s, you are at the mercy of what your employer’s 401(k) gives you in terms of investment options. While my employer offers me about 15 different investment options, they certainly run the board of what they do and how much they cost. Ideally you are looking for something that matches the Index and has a reasonably low cost. While some people get so caught up in the returns, many people barely pay attention to the expense ratio (this is how the fund makes their money by taking a little skim off of your return). It is important to note that even small changes in this ratio can have a big impact on your portfolio.

As an example: Let’s say that you make a one-time investment of $10,000 and let it grow for 30 years with an average return of 10%. Now let’s say Company A has an expense ratio of 0.50% and Company B has an expense ratio of 0.2.5%. While you might initially look at this and say that the different is so small (half of 2%), the impact of that over 30 years can be drastic. If you didn’t have any expenses, that $10,000 would grow into $174,494. If you went with Company A, you would end up with $152,203, paying a total of $22,291 in expenses, reducing your portfolio by 12.8%. However, if you went with Company B just because it was a more exotic or flashy investment, you would end up with only $87,550. You lost 49.8% of your investment due to just a difference of 2%!

Now that we have all of that established? What does this have to do with contributing to your 401(k) or not? Well what happens if your employer only gives you investment options that have insanely high expense ratios? If could be smarter to save some of your savings to go into a traditional IRA, as you have total control in picking the company and portfolio, you can make sure that your expense ratio is low.

Final Thoughts

You should contribute to your 401(k) to at least max out your employer’s match. Then take a look at your investment options and their expense ratios and returns compared to other options. If you are happy with your options, like a low cost index fund from Fidelity or Vanguard, then I would max out your pre-tax contributions. After that, you can decide whether you want to invest in your 401(k) with post-tax dollars or an IRA. Check out my next articles to find out the benefits from an IRA, what the difference is between a Traditional and Roth IRA, and learn about some tax hacks that only those in the Financial Independence community know about!

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About Dave 10 Articles

I’m the Common Cents Millennial and I am here to change how you think about your finances. Follow me as I struggle with student debt, side hustling, budgeting, lowering my expenses, and my path to early retirement. My goal is to go from $150k in student debt to early retirement in 15 years or less!

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