The 101 Class on Your 401(k)

By Geoff Schaefer

Geoff is a Wealth Advisor with Intergy Private Wealth. He writes for The Steadfast Fiduciary to help people live with an abundant heart, open mind, and boundless generosity.

December 1, 2023

They are one of the most common investment accounts in the United States, yet nearly 63% of Americans say they do not understand their 401(k) plan. 401(k) plans hold over $6.3 trillion in the US and that does not include retirement plans that are very similar such as 403(b), 457, and the Thrift Savings Plan (TSP). For most individuals, these types of plans provide the ability to save the largest amount toward retirement while also being the most convenient. Utilizing these plans properly are usually key to a good financial plan.  So, if you are among the two-thirds that are not confident in what your 401(k) is or how it works, here is the low down.

What is a 401(k)? 

It is a retirement savings account that provides tax advantaged savings for retirement. It is offered through an employer, so contributions are conveniently taken from payroll deductions and invested on an individual’s behalf.  Plans must include a variety of investment choices and often, an employer will contribute to an employee’s account as well in the form of matching or profit sharing.  With a few exceptions, these accounts have an age restriction on the withdrawals of 59.5 years old. These dollars are your dollars, so in the event of your employee going out of business, your money is still yours. Contrary to much of what is out there on TikTok and financial Twitter nowadays, they are not a scam and Indexed Universal Life Policies are not substitutes in any way.

What kind of contributions can I make?

When you contribute money, it falls into one of three classifications:  

1) Pre-tax: this means you get to deduct contributions from your taxable income today.  These contributions grow tax deferred and are withdrawn and are taxed at ordinary income rates.

2) Roth: this means you get no deduction on your contributions. The contributions grow tax deferred and are withdrawn 100% tax free.

3) After-tax: This is kind of a mix of the two.  There is no deduction on the contribution.  The growth is tax deferred, and the withdrawals come out mixed.  Any contribution (basis) comes out tax-free and any growth on these contributions comes out taxed at ordinary income.  The big benefit of after-tax contributions is that you can usually increase your contributions above the normal limit and you can roll after-tax money into the Roth classification every year.

Your age, income, net worth and goals can ultimately determine what classification is best for you. Talk with a financial planner or tax professional to figure out what is ideal in your situation.

What happens after I contribute?

An awesome part of 401(k) plans is the automatic investing that takes place once you contribute.  Most plans initially allocate your investments to a “target retirement fund”.  These funds match your age with a regular retirement date and those assets are invested in that fund to match that trajectory.  This year, if you have a target date fund of 2025, it is likely very conservative.  If you own a 2060 fund, it is the opposite end of the spectrum and allocated for growth. No matter, every contribution you make automatically goes into these investments with zero effort from you.  It is a wonderful level of automation.

How can I invest?

As I mentioned above, typically your investments will go into a target date option upon your enrollment into the plan.  These accounts also offer a variety of investments you can choose from.  On top of target date funds, plans will usually offer a few funds in each major investment category- US Equity, International Equity, Bonds, Stable Value/ Money Market, and Alternatives (see below picture for an example of what you may see). How you allocate these individual funds is a question that your financial plan (When Do I Start My Financial Plan) should answer and ultimately govern.

Many plans also have “brokerage link” options as well.  These options put all the investment selection risk on you and open the entire world of investing to you.  In an account like this, instead of only 20 fund options, you now have thousands of stocks, ETFs, mutual funds and potentially more you can invest into.

For more on investing check this out: Diversified Investing

What is vesting?

Vesting is a set schedule that determines when your employer’s contributions into your account are yours. YOUR CONTRIBUTIONS ARE ALWAYS 100% YOURS, but your employer’s contributions (matching and profit sharing) are not. There are two major types of vesting:

  1. Cliff Vesting.  All of the contributions are yours after a set period of time.  For example, after two years, 100% of employer contributions are vested.
  2. Graded Vesting.  Over a set period, you gain vested contributions incrementally. For example, 20% of contributions vest over 5 years after your first full year.  So, after 6 years you have 100% of the employer contributions. If you leave after two years, you get 20% in contrast to the cliff vesting which would have given you 0%.

What is the limit for contributions?

This answer typically changes every year. For 2024, it is $69,000. That is the limit for both employee and employer contributions. The limit for your own contributions, employee contributions, is $23,000.  There is also a catch-up contribution of $7,500 if you are over the age of 50.  So really, you could squeeze out $76,500 of total contributions if you are 50 or older. The last limit to consider is your earned income.  Your contributions cannot exceed your earned income.  So, if you make $20,000, you cannot contribute the $23,000.  It seems obvious, but worth mentioning.

Here are some examples:

Example 1: Joann is 30 and makes $200k at her job.  She saves the maximum of $23,000 next year and her employer matches 5% of her contributions.  This means the employer adds $10,000 more throughout the year making her total contributions $33,000.  In December, her employer decided to profit share to every employee’s account by adding a 3% of salary contribution. The profit share brings the total 2024 contributions to $39,000. $23,000 is her own and $16,000 is from her employer and subject to vesting.

Example 2: Bill is 45 and makes $350,000 at his job.  His employer puts 16% of his salary into his 401(k) account regardless of whether or how much he contributes. This means, throughout the year, his employer adds $56,000 to his account. Bill adds $13,000 of contributions getting him to the annual maximum of $69,000. 

Example 3: Same bill as in example two, but he wants to contribute more of his own dollars to maximize Roth contributions. He adds $23,000 throughout the year.  His employer can only add $46,000 to his plan because of the $69,000 cap.  So, $10,000 will likely be added to Bill’s annual salary or rolled into another account- all depending on what his employer has established.

Example 4:  Sandy is 58 and makes $150,000.  Her employer matches 5% at the end of every year.  Sandy saves $30,500 into her plan- $23,000 of regular contributions and $7,500 of catch-up contributions. Her employer adds another $7,500 for the 5% match.  Her total contributions are $38,000 for the year.

Look for special features in your plan.

Some plans have more features than others.  Usually, the larger the company, the more options that exist, but this isn’t always the case.

Some examples of plan features include:

  1. 401(k) loans– the ability to loan against the balance of your account.
  2. In plan conversions– the ability to convert after-tax or pre-tax contributions to Roth without having to withdraw any of the funds
  3. Savings rate automatic increase– I love automation.  This feature allows you to set a percentage or dollar amount that your contributions increase annually.
  4. Hardship withdrawals– withdraws that can occur in special circumstances, but still subject to taxes and penalty fees.
  5. Automatic rebalancing– resets all funds to your set allocation at certain intervals, usually annually or semi-annually.

Lastly, what happens to my funds after I leave my employer?

Great question as there are currently about 29 million forgotten 401(k) plans. Please do not add to this number.  If you leave your employer, after 30 days, you can do one of these options:

  1. Roll into your new 401(k).  If your new plan accepts rollovers (not all do), this can be an easy and quick fix.
  2. Roll into an Individual Retirement Account (IRA). Just as easy as the first option and could give you flexibility when it comes to investment choices and potential tax-planning around Roth conversions.
  3. Withdraw everything.  Probably not the best idea, but it might be a consideration for some.  If under 59.5, you will face early withdraw penalties.  If over 59.5, you may just pay some taxes.
  4. Keep the money there. 

If you have an old 401(k), try tracking down an old statement and make a phone call to the 401(k) provider to get info on your account. You can also search databases like Unclaimed Retirement Account Database for your old plan.

Employer sponsored plans provide an amazing benefit to employees. The tax benefits provided in the account along with the potential employer contributions make it as close to a must have for financial planning that exists out there.  Investing is part of financial planning and retirement planning, and this account is one of the best at supporting those aspects of planning.  If you have questions on how your plan works or are unsure about the investments within your account, reach out to a fiduciary financial planner for assistance.

I’ll leave you with this example of a very ordinary person who chooses to use the account. The median salary in the US in 2023 is just under $60,000. So a person makes $60,000 every year for 40 years, never gets a raise. No chance of retirement you may think? Well, good thing they had a 401(k) that offered a 5% match. For 40 years, they contributed 5% and received the full match. That 5% contribution with the 5% match, invested in the S&P 500 over the last 40 years would have resulted in a total invested amount of $245,500 (only $122,750 of that actually coming from the individual) and the account balance as of December 1st, 2023 would be $3.503 MILLION!! An average return of roughly 11% annually. If that person decides to continue to live off $60,000, they can pull less than 2% of their portfolio out per year and be just fine. Your 401(k) will work if used properly.

The best time to invest was yesterday. Whether you are 24 or 54, invest for the future. A 401(k) could be a really great place to do just that.

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