401k, IRA, Roth… What Does it All Mean and How Can We Maximize Wealth?
A 401k: Should I contribute?
I remember as a young college kid, hearing words like 401k, Roth, IRA, and they were so confusing. I seriously thought 401k was the amount of money ($401,000) you had to invest before you could use the account. I was so naive (just like the guy in the picture). However, not all of us need to be this dense! With a little knowledge, you can take advantage of these retirement vehicles that the government has set up to build STEALTH WEALTH.
What’s the 411 on the 401k And Other Retirement Saving in America Today?
It’s a disaster. It’s a full-on dumpster fire. — According to a Personal Capital-sponsored study conducted by ORC International, almost 37% of people have no money saved for retirement. Also, only 63 % of Americans with full-time employment participate in an employer-sponsored retirement program, and to add insult to injury just 21% max it out.
If your employer offers a retirement plan, like a 401(k) or 403(b), and will match a percentage of your contribution, get on that like white on rice. If you don’t, you are giving away free money. When we hear these stories of people not contributing to the 401k, it makes The Stealthy Rich sad. Plus, if you do commit to your 401k, you’ll have a tax-deferred account that makes it easy to automate saving through a regular payroll deduction.
What is a 401k?
A 401(k) is a retirement plan that your employer provides, and it’s designed to incentivize saving for the future. It lets you save a portion of your paycheck before taxes are taken out. This means for every dollar you put in your 401k, that’s a dollar on which you don’t pay federal income tax now. (You’ll pay later though, don’t worry.)
401(k) plans, are named for the section of the tax code that defines them (not how much money you need to open one :), and came about during the 80s as companies started to say “Sayonara” to the pensions as they were too expensive to maintain. With a 401(k), you have some options on how you invest your money. You can choose from the funds in which your employer has allowed you to invest. Usually, plans contain a range of mutual funds composed of stocks, bonds, and cash. Some even have target-date funds like a 2045 fund which automatically adjust the asset allocation with time to become more conservative as you get closer to your retirement date of “2045”. The ultimate “set it and forget it” strategy. Usually, these funds have very low expense ratios as well, so we like them if you genuinely don’t want to think about it and would rather keep stuffing in money.
While a 401(k)can help you save, it has a fair amount of restrictions. In most situations, you can’t access your employer’s contribution for a specific time frame. Most companies have a “vesting” period which defines how long you have to work there until you “earn” that juicy free money match. It helps incentivize employees to stick around a while in any given job. If you leave before the vesting period, then you get zero or only a prorated portion of the money matched. On top of that, there are complex rules about when you can withdraw your cash and costly penalties for pulling funds out before retirement age.
With that settled, how much should you put in your 401k?
So how would a 4% match work? If your employer matched the first 4% of your salary and you put in 4% of your $60,000 salary, or $2,400, your company would add another $2,400 in the account. You can add more than that $2,400 yourself, but the company won’t match beyond 4%. The rules for matching are different, so ask your HR department if you are unsure. The great thing is that in 2019, you can put $19,000 into your 401k. This means that if you are in the 22% federal income tax bracket, and you contribute $19k into your 401k, you will save $4,180 in federal income tax in 2019 (.22 * 19,000). Huge.
Now the downside is that when you decide to take that money out after you’ve reached the ripe age of 59.5 (who came up with that number??) and it has grown for years and years, you will have to pay income tax on the distributions you take out.
Today’s savings situation in America summed up in one picture…
Roth 401k Option (There’s always a plan B (well only if your employer offers it)
Your employer might offer a Roth 401k option as well. These work just the same as a traditional 401k except for one vital difference.
In a Roth 401k, you contribute AFTER-tax dollars, and then those dollars grow over time, and then you pay NO taxes on any distributions during retirement.
So the ultimate question is, should you pay taxes on the money now, or money in the future (Roth 401k)?
It’s a nuanced answer and one The Stealthy Rich wrestle with all the time.
The question you should be asking is, do you think your tax rate will be higher now or higher in retirement?
If your employer doesn’t offer a 401k plan, then an Individual Retirement Account (IRA) could be an excellent start to your retirement savings and another opportunity for your earnings to grow tax-free. We will talk about that in the next article. Stay tuned.
