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What is a 401k Plan?

401k-plan

Personal Finance

What is a 401k Plan?

A 401k plan is the primary retirement savings vehicle for many working Americans. Whether you are new to the workforce and have contributed for several years, you might be wondering exactly what is a 401k plan.  If so, this article will help you understand your 401k plan and learn how to maximize your retirement savings.

How a 401k Plan Works

The formal name for a 401k plan is a defined contribution plan. Unlike pensions where the employer pays most of the cost for retirement, a 401k is mostly funded by the worker. Your employer has the option to provide a matching contribution if they choose to. For instance, they might match the first 6% of your gross salary.

With each paycheck, you contribute a designated percentage of your salary. It can be 0%, 5%, 10%, 75%, etc. You can contribute as much as you like, just keep in mind that the annual contribution limit is $18,000.

With your contributions, you can invest within any of the available funds within your employer plan. Most plans offer between 5 & 30 different investment options.

Employer Matching Contributions

Employers aren’t required to offer a matching contribution, but, many do. If your employer offers a match, you should at least contribute enough to maximize the match. It’s essentially “free” money.

Even if you don’t contribute beyond the matching amount to your 401k, you need to earn the entire match. After several years of matching contributions, you will be surprised to see how much your 401k plan has grown in size from these regular cash installments.

Traditional 401k vs Roth 401k

There are two different types of 401k plans available, a Traditional 401k plan and a Roth 401k plan. Traditional & Roth 401k plans have the same tax treatment as Traditional & Roth IRAs.

A Traditional 401k plan is tax-deferred. This means your contributions are made on a pre-tax basis. This lowers your taxable income for the current tax year, but you will pay tax on the capital gains when you make a withdrawal in retirement. Until you withdraw, you will not pay annual taxes on dividends and interest like you would with a non-retirement investment account.

The relatively new Roth 401k plan is tax-free. Like a Traditional 401k plan, your investments grow tax-free each year. But, because the contribution was made after income taxes were already withheld from your paycheck, you won’t pay any taxes when you withdraw the funds in retirement.

Which 401k Plan is Better?

One of the largest debates among retirement planners is deciding if a traditional 401k or a Roth 401k is the better financial option.

A Traditional 401k plan is better when:

  • You plan to retire in a tax bracket similar or lower than your current tax bracket
  • You want the income tax deduction now instead of tax-free withdrawals later
  • Your employer only offers a Traditional 401k

A Roth 401k plan is better when:

  • You plan to retire in a tax bracket higher than your current tax bracket
  • You don’t want to worry about a higher-than-expected tax in retirement on earnings that have grown tax-deferred up to 40 years
  • You don’t need the immediate tax deduction, allowing your contributions to grow completely tax-free

In a nutshell, traditional 401k plans require you to pay the tax later. Roth 401k plans require you to pay the tax now. This might be the easiest way to determine which plan is better for you. Of course, you can always contribute to both types of 401k plans as nobody can predict our future financial health with 100% certainty.

One additional side note. Matching employer contributions must be “pretax” so a portion of your 401k balance will be a traditional 401k plan, even if you contribute 100% of your personal contribution to a Roth 401k plan.

401k Investment Choices

With a 401k plan, you are only allowed to invest in a select number of funds that belong to your 401k plan. If you don’t like the investment choices in your 401k plan, you will need to invest in an IRA for tax-advantaged retirement savings.

What Is a 401k Plan

Your 401k Investment Choices Should Have A Few Different Choices In Each Asset Category

If your employer partners with Vanguard to administer their 401k, you might have the same choice of several funds above. If you want to invest in another  Vanguard fund such as VTSMX instead of the other domestic stock fund options, you will most likely have to invest in that particular fund with an IRA. Very few 401k plans allow you to invest 401k contributions in assets outside your current plan selection.

When investing in individual index or mutual funds feels too overwhelming. Most 401k plans also offer target date retirement funds that will automatically shift your contributions to a more conservative allocation as you near retirement.

Most 401k plan administrators (i.e. Vanguard, Charles Schwab, Fidelity) also offer an advisory service for an additional fee of approximately 0.35%. This is another great way to confidently invest for retirement when you know little about stocks and bonds.

401k Plan Fees

Every 401k plan has fees and administrative costs. Some 401k plans are more expensive than others because they invest in funds with high expense ratios or charge annual maintenance fees.

By law, your 401k plan is supposed to disclose how many fees you pay each year. The figure should be included on your monthly statement.

The cheapest 401k plans only charge you the fund fees that you pay whether you have a retirement or non-retirement investment account. As an example, if your $50,000 portfolio has a 0.15% annual expense ratio, you will pay approximately $75 in fees each year. If the expense ratio is 1.00%, you will pay approximately $500 in annual fees.

This is why it’s so important to choose well-performing funds with low expense ratios. It means more money in your pocket to spend in retirement.

What about Expensive 401k Plans?

Sometimes contributing to a 401k plan isn’t a good idea. This is if your only investment options are significantly more expensive than investing in similar low-cost funds in an IRA. You might consider not investing in your 401k plan when your average fund expense ratio is 1.00%+ when you can invest in similar mutual funds with an expense ratio of 0.35% or less.

A second option to invest outside your 401k is if your employer requires you to pay the account maintenance fees. These fees are in addition to the annual operating expenses that each individual mutual fund you hold charges.

If your employer offers matching contributions, you should still strongly consider contributing enough to maximize the match. When the fees don’t justify the match, you should just invest entirely in an IRA. Participating in a 401k plan is optional, so don’t feel obligated to contribute to remain employed.

Summary

A 401k plan can be one of the easiest ways to save for retirement. This is because your employer automatically withdraws the same percentage of money from each paycheck. Whether you enroll in a traditional 401k plan, Roth 401k plan, or both, you will save thousands of dollars in annual investment income taxes as you only pay taxes once. And, it’ll earn more money than keeping your money in a bank account.

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