How Do 401Ks Work?

The term 401K has become fairly commonplace in the world of investing and employee benefits ever since the accounts were introduced in 1978. Most full-time employers nowadays offer 401(k) accounts as part of their overall benefits package, with many offering employer contributions to help you save more.

Let's take a look at some 401k background, understand how they work, and help determine whether you should be taking advantage of your 401k options.401ks started in 1978 after a portion of the Internal Revenue Code was updated with section 401k stating that a specific type of investment savings account that allowed taxpayers a break on deferred income as well as employers to help with contributions.

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This marked a shift in employee retirement structures, away from pensions and to employee-funded accounts. This gave workers more freedom in where they worked and for how long, however, it did put all the responsibility of retirement on the worker, not the company.

Contributing money to 401k plans allows you to tax defer the amount you've contributed. This means that the contributions you make in any given fiscal year are subtracted from your gross income before your income tax is calculated. You do still pay tax on the money, however, just when you take the money out at the age of retirement. In general, 401k plans allow for you to start taking out money at 59 ½, depending on your plan rules.

All of this may sound simple, but let's take a look at an example of how this can be applied to maximize your retirement benefits and minimize your tax burden now.

401k savings example

If you make $100K per year and you contribute 15% of your pay, the expert-recommended amount, to 401k plans, that comes out to $15,000 per year. Getting paid twice per month, you'll have 24 paychecks throughout the year, meaning that each paycheck will have $625 dollars deducted pre-tax and placed into a 401k savings plan.

When you file income taxes at the end of the year, your income will no longer be $100,000, rather it will be $85,000, as you won't be taxed on your 401k contributions. Getting taxed on $85,000, assuming no other deductions, would mean you'd pay roughly $14,000 in taxes for that year, compared to if you were taxed on the full $100K, you'd pay about $17.5k in taxes. At the end of the day, the 401k play allowed you to save 15,000 in income, while also saving $3500 in taxes compared to if you had just put that 15,000 in a savings account.

Ultimately, this helps you maximize your retirement savings while also helping you save money on taxes now. Not to mention, most employers have 401k matching, so if your employer matched 75% of your contributions up to $5000 (a somewhat typical matching rate), you'd get an extra $5000 in savings from your employer, tax-free, that you wouldn't have had before. Meaning that participating in the 401k plan, in this instance, saved or made you, depending upon how you look at it, roughly $8500.

In general, you should always make sure you contribute enough to get the full matching contribution. It's essentially free money on top of your base salary up for grabs. You may not get it now, but retirement you will definitely thank you later.

Compounding interest

One of the biggest reasons to participate in 401k plans as soon as possible is due to compounding interest. In general, you can earn roughly 6% per year on your 401k investments. This means that if you invest $10,000 once at age 25, by 65, that will be $120,000. This is simply what happens when money is allowed to earn interest each and every year, but the effect is maximized the more time you leave the money in the account. Contributing 10,000 at age 35 would only transform into $60,000 in retirement. It's only 10 years later, but it's half the retirement money. Start saving early and start saving as much as possible.

Now, there is another type of 401k plan too, one that doesn't allow you to defer tax and rather makes you pay taxes on your contributions now. There are some advantages to this plan called a Roth 401k.

Roth 401k

Roth contributions function essentially the same way as just putting money in a savings account would when it comes tax time. In other words, you're still taxed on your contributions in the year you made them. However, you aren't taxed on that money in 40 or so years when you take it out.

This ultimately means that over the span of your life, you have a smaller tax burden in sheer numbers. Getting taxed on $10,000 of contributions is monetarily less than getting taxed on $100k in 40 years when you take that $5000 out. Roughly it's the difference of $2,400 in taxes versus $24,000 in taxes. That's a lot of money, but Roth means you take on all the tax burden now, which some people may want to avoid.

There's another note to mention here. The U.S. Government has a cap on 401k contributions. In the current fiscal year, the cap is $19,500. This only applies to your contributions, not employer matching contributions. This cap is also different if you're over 50 as the IRS allows an additional $6500 in "catch-up" contributions on top of the $19.5K limit.

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So, should you contribute to a pre-tax 401k or a Roth 401k? If you earn a lot of money each year, meaning you fall into a high tax bracket, it's likely better to contribute to a pre-tax 401k. However, if you aren't in a high tax bracket, then Roth is likely the right way to go.

You can also invest in both and shift at any time. A general rule of thumb is to invest in Roth in your early career, then shift to pre-tax as you get older. However, what's best for your specific situation can really only be figured out by calculating the numbers.

When do your retirement savings vest?

So, after you've saved all of the money you need for retirement, when do you actually get it? Each plan is different and generally follows a vesting schedule. General rules of thumb are that you can't take money out without fees until 55 or 59 depending upon the plan. However, you can take the money out at any time, you'll just be charged hefty fees in doing so before the set time.

The money is always yours, it just has some regulations on how you can use it before retirement age. That said, many 401k plans also allow you to take out low-interest loans using your entire 401k amount as collateral. This can provide 401k participants some solace if they ever fall upon hard times.

401k plans are also more than just set it and forget it plans. You not only contribute money, but you get to decide how the money gets invested and allocated. Depending upon your age, you'll want to set risk appropriated. Most 401k plans, if not all, will have specific portfolios you can select depending upon when you are planning on retirement. These will be managed and are in general some of the safest ways to manage risk in your account.

However, if you have some investment smarts or just want to be riskier with your money hoping for higher return, you can set your own investment portfolio leveraging more of your money into more volatile stocks or funds. This provides you more possibility for large growth, but it also means you could lose money if you're not careful.

401k plans, in the US at least, are some of the most powerful ways you can leverage your income and make your money work for you. If you don't have a 401k plan through your employer, look into other investment accounts like IRAs. These function in similar ways as 401ks, but are a little beyond the scope of this video.

At the end of the day, make sure you are saving for retirement as early as possible. This will allow you to maximize compounding interest and transform your initial contributions into as much as possible.