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Saving for Retirement - What is a 401K?With ongoing concerns about the future of Social Security, saving for retirement today is more important than ever. Back in the good old days, the best retirement plans were built around a corporate or government pension plan -- some lucky folks still get those today. These were known as defined benefit plans, meaning the company or government entity committed to a specific level of payouts (benefits) for the life of the participants once they reached retirement age. The company had to set aside reserves to fund these liabilities. With a defined benefit retirement plan, you know exactly how much you will get in the future, and companies are on the hook for a lot of money going forward. The alternative pension plan is called defined contribution plan. A defined contribution plan calls for a specified annual contribution to a pension account, but no future liabilities or obligations once the contributions end - your future benefits depend on how much is in the account, how it is invested, and how much is taken out of it each year. It could last you through 10 years of retirement or 40 years. In this guide, we will take a look at a specific type of defined contribution plan called the 401K - what they are, how 401k's work, what the tax implications are on both contributions and distributions, and more.
How do 401k Plans Work?What is a 401K plan? The name comes from the section of the IRS tax code that it falls under - section 401K. It defines a 401(k) as a qualified defined contribution pension program, in which employees can elect to have their employers contribute a portion of their pre-tax wages into a 401K account. The account is held in the individual's name but is run and managed by an administrator -- sometime the company themselves or a financial institution like a bank or investment company. The wages that go into the pension account are called "deferred wages", which basically means the IRS does not see or record them or tax them as wages for now -- all that is deferred until you begin withdrawing money from the account, which is called distributions. What this means to you is that any money you put into a 401K account this year DOES NOT show up on your 1040 tax return as income. So if you made $50K this year and put $5K into a 401K account, your tax return would show only $45K of income, and you'd show $5K in deferred pension contributions. Once the money is in the hand of the 401K administrator, you can't get it back without them filing a form with the IRS (1099-R pension distributions), so the IRS will know when you do start accessing that money and will expect to see it on your tax return as income. So how does it work once the money is in there? Most plans allow you to make your own investment decisions, selecting between a variety of mutual funds or bond funds. Some companies automatically invest the funds in their own company stocks (think Enron!) -- watch out for this and remember to diversify - you don't want all your income and all your retirement riding on your bozo CEO, do you?? So your money sits there, invested in various options, for years and years. The nice thing is that all transactions and gains in the account are TAX-FREE as long as the money is not withdrawn. You file no special tax returns, you don't have to worry about tracking gains or losses from each trade you make, you don't get dinged for capital gains tax payouts made by mutual funds -- whatever happens in that account, there are no tax concerns and no tax consequences.Why is this? Well, remember, the account is tax deferred. You have not paid one cent of tax on the money you put in there, and you have not paid one cent of tax on all the investments gains you have made for the 30 years the money has been sitting in there. So what's the catch? Well, the government will begin to tax you once you start taking distributions out of the account, and then it counts as regular income on your tax return. So whether you put the money in, your employer put money in, or most of the money has come from decades of dividends and capital gains, it will all be taxed as regular income when you begin to withdraw it. The goal is to be retired at that time with little or no regular income, so your 401K withdrawals will be taxed at a lower tax rate than you would have been paying when you were working. Will I save money with a 401(k) plan? Should I invest in my company sponsored 401(k) program?You'll here most financial consultants and accountants tell clients they should put as much deferred income as they can into 401K plans run by their employers. So what are the advantages of investing in a 401K account? For most people, this is a good idea for 4 reasons. The first is obvious - you have a reduced income tax bill the year that you do it, since any money you contribute is not counted as income that year, effectively reducing your income, and your income tax due, so more money in your pocket and not in Uncle Sam's. Second, the money in your 401K account is allowed to grow tax-free as long as it is in there, letting it compound and grow faster. How does this help you? Let's say you have $10K in your 401K and $10K in your stock trading account. This year, you make some great stock picks and double your money, buying the same stocks for both accounts. At the end of the year, your 401K account is worth $20K, and so is your stock trading account -- uh oh, but now you have to pay short term capital gains tax on those gains - let's say 35% of that $10K. So your stock trading account ends the year at $16,500. Suppose you have another terrific 100% gain year -- the 401K account jumps to $40K in value (still no taxes being paid), while your brokerage account doubles to $33K, then you pay taxes on the $16.5 gain ($5775), leaving you with just over $27K. You get the picture - it is better to let gains sit and compound year after year instead of losing 20-30% of them in the form of taxes. So remember that, your investments in your 401K account DO NOT GET TAXED until you take the money out. If you have a hot stock idea that you think is going to appreciate a lot, buy it in your 401K account where you can keep the gains untaxed, and buy the more boring stuff in your brokerage account.That brings us to the 3rd advantage - employer matching contributions. Many employers contribute to your pension fund by matching some or all of your contribution -- you put in 3% of your pay, they match that 3% for a total of 6% of your wages going into the 401K. Stop and think about this for a second. You have $5000 and put it into your 401K account, your employer matches your $5K and now you have $10K in your account. This is a 100% instant gain for you - you turned $5000 of retirement income into $10K instantly, with no risk, no work, nothing. That is something you just can't turn down, and is probably the MOST important reason to put money into your company sponsored 401K at least up to the point that they offer to match it. Even if you were forced to withdraw all your money, pay all the taxes and penalties, you would still come out slightly above even, so you really can't lose anything even in the worst case scenario if your employer is matching your contributions. That brings us to the 4th benefit of these defined contribution accounts. They are tax deferred, meaning you don't pay taxes on the money when you earn it, you pay deferred taxes on the money when you eventually retire and take it out and begin spending it. This works out great if you are making $200K/year right now and are paying 40% combined taxes to federal and state tax authorities. You save 40% of the money you contribute right now, and hopefully when you retire and your regular income drops significantly, you will find yourself in a lower tax bracket when it comes time to pay taxes on this deferred income - maybe 25% instead of 40%. This is a gamble you take when putting aside this money - you are effectively betting that tax rates will be LOWER for you in the future than they are now. If they are higher in the future (think unfunded Social Security and Medicare liabilities, huge defense spending, etc.) then you may well have made the wrong choice, trading in 40% tax rates today for 50% tax rates in the future. With employer matching funds and compounding un-taxed gains over the years, you might still come out ahead, but consider the math first.. Let's say you have no employer matching contributions. You contribute $10K of your income to a 401K account this year, instead of paying 40% tax on it, which would have left you with $6K. Let's say you did this for just one year, and then let the money sit for 20 years over which time it triples. So you have two alternative scenarios - take the money now and pay taxes on it and invest the $6K which grows to 3x6=$18K, or put the money in your 401K, pay no taxes now, so the whole $10K triples to $30K 20 years from now. So which is better, $18K in the future with only capital gains taxes due, or $30K in the future with full federal and state taxes still owed on it? If you are still in a 40% combined racket in the future, and you withdraw the $30K, you pay 40% taxes and end up with $18K. If taxes are higher, you end up with even less. If taxes are lower, you end up with even more. So that's part of your risk - trying to guess what the taxes will be decades from now and trying to guess what tax bracket you will be in at that time. If you have employer matching funds, those risks are so greatly reduced that it is almost a no-brainer to at least contribute the maximum to to win the employer matching portion. What are the disadvantages of a 401K account?There are a few disadvantages to investing in 401K plans. The first is that money that would have been in your pocket to spend as you wish (travel, start a business, lend to a family member in need, etc.) is now effectively out of your hands and locked up in a retirement account. True, you can still borrow against a 401K account in situations involving buying a house, paying for education, medical bills, etc. but many of your options are gone -- you just can't get to the money as easily as you could if it was sitting in your bank account. Second, if you do need the money and withdraw it before 59 1/2, you pay a 10% penalty on top of any federal and state taxes due on it - this could easily amount to almost 40-50% of all the money in the account. So if your 401(K) statement shows a balance of $100K and you need to withdraw it all early for launching a business or something, you might only get $50-$60K back after taxes and penalties, so you have a lot less than you think. Third, it's hard to guesstimate what your tax bracket will be 30 years from now - are you better off paying taxes today and getting your money now, or letting the money sit out of reach and paying taxes on it 30 years from now? I'm not sure anyone has that answer - hopefully your tax rate will be lower in retirement, but maybe you successfully invest in real estate and have lots of rental income or something, or launch a business that brings in money for decades, and your tax rate never goes down -- then there is not much benefit from having locked away all that money for so long. So to make wise 401K investing decisions, you need to consider a few factors. If you are in a very low tax bracket with no employer matching, there may well be NO REASON to invest in a 401K account your company offers - you are better off paying the known 10-15% of taxes due today and keeping the remaining 85-90% of your wages and investing it on your own outside of a 401K account, like a ROTH IRA, rather than risking that 30 years from now your tax rate will be lower than 10-15%. If you are a higher wage earner or have the option of employer matching funds, then chances are a 401K investment is a very wise decision.
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