What About My 401(k)? Retirement Planning for Newbies

By January 15, 2019 Blog No Comments

Working in the tech industry comes with a lot of perks and benefits, but none are quite as ubiquitous and helpful as a 401(k) plan. However, for a lot of people, they don’t really understand how this plan works and how they can maximize its potential.

Unfortunately, not understanding your 401(k) can cost you a lot of money in the long run, meaning that the sooner you can get up to speed, the better off you’ll be in retirement. So, with that in mind, I want to take the time and go over the ins and outs of your 401(k) and retirement planning in general.

What is a 401(k) plan?

Simply put, this is an employer-offered benefit that allows employees to save for retirement. However, what sets this apart from doing this on your own is that your employer will sometimes (not always) contribute money into your account, meaning that you can increase your earnings by a pretty wide margin.

The other element of a 401(k) is that you get tax benefits as well. Because you want to keep as much of your money as possible, you want to figure out the ideal way to pay as few taxes as possible, which I’ll get into later on.

Benefits of Having a 401(k)

Tax Deductions – when you contribute money into your account, you can usually write them off as deductions, meaning that you can save more in the short-term while saving for the long term.

Employer Contributions – if your company does match your contributions, then it’s free money that will earn interest.

Compound Interest – the more you put in and the longer you wait to take it out, the more that your money will grow. Compared to other retirement savings accounts, a 401(k) is going to provide some of the best interest rates.

Withdrawal – although I never suggest that you take money out of your account, it’s there if you’re ever in a tough financial bind.

Portability – since it’s your money in the account, you can take it with you when you switch jobs. While employer contributions can be affected depending on a few factors (which I’ll cover), you can still keep what you put in.

How Much Can I Contribute?

When you learn the benefits of having a 401(k), it’s natural to get a little carried away and start putting as much money as possible into it. However, there are limits as set forth by the federal government. In fact, the term 401(k) refers to the tax code that lays out all of the rules about this plan.

Every year, the government raises the maximum contribution to keep up with inflation. In 2018, the maximum you can put into a 401(k) is $18,500 for the year.

If, however, you’re trying to catch up because retirement isn’t far off (i.e., you’re over 50), then you can contribute an additional $6000 per year, making the total $24,500. If you have multiple 401(k) accounts, the grand total for everything is $55,000 annually.

How Much Will My Employer Match?

When signing up for a 401(k), it’s imperative to understand how much your company will add into your account. Typically speaking, the best thing to do is contribute at least as much as they’re willing to match.

In some cases, employers may not add anything to your account. In most instances, however, they will match up to 3% of your salary, although some will go as high as 6% or more.

The other thing to consider is that most businesses won’t match dollar for dollar. In many cases, they’ll only contribute up to 50% of your additions, with a cap at 3-6%. Thus, if you add $1000 from your paycheck, they’ll add $500 until you max out. 

To give you some perspective, here are the matching contributions for some big tech brands. (Note: these numbers may change with time)

  • Facebook – 50% contributions, up to 7% of salary
  • Google – 50% contributions, max $8,250 total
  • Apple – 50% contributions, max 6%, up to $8,250
  • Airbnb – no 401(k) matching

If I Leave the Company, Do Their Contributions Go Away?

Because switching companies is relatively common in the tech industry, it’s natural to wonder if the free money you earned from your employer will disappear as soon as you do. You’ll have to find out the specific details of your plan to get the answer to that question.

Typically, companies will incentivize employees to stay longer by saying that their match contributions will only stick if you’re around for a particular amount of time (i.e., five years). If you meet the requirements, the money’s yours no matter what.

What Investment Options are There?

Usually, companies will offer a variety of mutual funds and bonds for you to put your 401(k) money into. However, IRAs are going to be your best friend when it comes to taxes. There are two types of IRAs – standard and Roth. Let’s look at the difference between them.

Standard IRA – you don’t pay taxes until you withdraw the money. This is the same way that your 401(k) funds work, which is a great way to save in the both the short and long-term.

Roth IRA – you pay taxes now and then don’t pay anything when you withdraw.

To put it into perspective, let’s use a metaphor. Pretend that you’re a farmer, and you have to decide when to pay taxes on your crops. You can either pay them on the seed or the harvest.

If you pay taxes on the seed, then when the harvest comes in, you get to reap all of the rewards (Roth IRA). If you pay on the yield, then you don’t have to do anything now, but you could wind up paying big if you bring in a lot of crops (Standard IRA).

Typically speaking, your income tax bracket is going to be higher now than when you’re retired. Also, if you’re putting money away for a long time (i.e., 40 years), you can expect it to grow significantly from now until then.

To help you make the right decision, let’s look at the three aspects of investing – time, risk, and asset allocation.

Time – the longer you invest your money, the more it will grow. Also, you can absorb short-term losses because your net gain will be more significant in the end. Simply put, short-term investing pays less than long-term.

Risk – if you want to make more money, you have to put more at stake. High-risk investments can have a much higher yield, but there’s also a chance that you could lose more. Thus, you have to determine how much risk you’re willing to take on.

Asset Allocation – as they say, don’t put all your eggs in one basket. It’s never a good idea to have most of your money in a single investment, just in case it backfires or disappears altogether. Spreading your assets out can lower your risk and keep your money safe.

Overall, mutual funds and bonds are great for low-risk investments, but you want to keep your money in them for a long time to get any kind of growth. IRAs are going to be your best option because they have better interest rates, but you have to decide whether you’re going to pay taxes now or later.

How are Taxes Determined With 401(k) Contributions?

There are several ways that you can save money on taxes with your 401(k) account. Let’s break down how it all comes together.

Pre-Tax Deduction

First and foremost, any money that you contribute into your 401(k) will be deducted from your gross salary. Thus, if you make $50,000 per year and put 10% ($5,000) into retirement, you’ll only be taxed on the remainder, or $45,000. Thus, you can potentially enter a lower tax bracket and save even more.

Deferred Tax Payment

With standard 401(k) plans, you pay taxes only when you withdraw the money, which is based on your current income. If you’re retired, that will be lower than what you’re at currently (typically speaking), which means that you can save money when you take it out.

No Taxes on Interest or Capital Gains

If you put money into a savings account, you pay taxes on it every year, including any interest you may earn in the process. In a 401(k), the interest that accrues for the life of the account is not taxed, meaning that more of it goes into your pocket.

Can I Withdraw Money From my 401(k)?

In some cases, if you have enough saved in your account, you can take out a loan and borrow against what’s in there. Usually, the cap is 50% of the total, up to $50,000.

However, if you do this, then you’ll have to pay penalties and fees. Usually, it’s 10% of the total. Also, since it’s withdrawn as a loan, you’ll have to pay interest on it. Fortunately, most of that interest will come back to you, but it’s not going to have the same advantages as it would if you put the money in directly instead.

Bottom Line – Contribute More, Start Early

When retirement comes, you need as much money as you can get. Unfortunately, most Americans don’t have anywhere near enough saved, which can create a dire financial situation. When it comes to your 401(k), here are my recommendations.

Start as early as possible. The longer it sits in the account, the more tax-free interest accrues.

Contribute more than the match (try to max out if possible). More money means more money, which is going to pay off in retirement. While matching is nice, don’t let it hold you back.

Make sure it vests before moving. While it’s not always possible to delay switching companies, try to wait until your matched money is secure.

 

Resources: https://www.fidelity.com/viewpoints/retirement/cashing-out

https://turbotax.intuit.com/tax-tips/investments-and-taxes/the-tax-benefits-of-your-401k-plan/L8QHCzbiO

http://time.com/money/collection-post/2791208/what-happens-to-401k-after-job-change/

https://money.cnn.com/2017/10/19/retirement/401k-ira-contribution-limits-2018/index.html

https://www.fool.com/retirement/our-guide-to-401ks-for-beginners.aspx

https://www.thebalance.com/401k-retirement-plan-beginners-357115

About Woven Capital

Aaron Hatch is a Certified Financial Planner and co-founder of Woven Capital, a fee-only financial planning and investment management firm that specializes in helping people balance life, work, and community. Aaron has been quoted in various publications, including The Chicago Tribune, US News and World Report, and the Huffington Post among others. Aaron can be reached at aaron@wovencapital.net