The 411 of the 401(k)

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This post is part of Allese’s (Community Manager at Wesabe) blog series detailing her journey into the real world of finance. Check it out and send her your tips!

Nearly two months ago, the HR woman dropped by my desk and asked what percentage of my paycheck I’d like to contribute to my 401(k). I stared up at her with a blank face, mentally linking 401(k) with retirement and said,

Allese: “Yeah.. umm so what’s the deal with that? That’s saving for retirement right?”

HR: “Yes, we use Vanguard.”

Allese: “Right… and that’s like an investment company?”

HR: “Yes.”

Allese: “I see. So I have to, like pick places to invest in?”

HR: “Well you can if you want, or you can pick a fund and go from there.”

Allese: “A Fund. And that’s a…. ?”

HR: “Well, it’s a place you can invest you’re money for retirement in, you know like shares, stocks, bonds.”

Allese: “So I put part of my paycheck in this fund that I pick, which is part of a stock market and so then it, it, it well, well… what exactly happens then?”

HR: “Well it’s pre-taxed, so you know.”

Allese: (No, I don’t know. In fact, I have absolutely no clue what this woman is talking about. In an attempt to salvage my dignity, I reply): “Yeah… I am going to have to do some googling. But I will get back to you. Thanks!”

Now, I consider myself a fairly intelligent, capable individual. That said this conversation left me highly suspicious of these qualities. Looking to redeem my self worth, I turned to my ever-faithful friend, Google, for a simple breakdown of this 401(k) issue.

Google:

The 401(k) plan is a type of employer-sponsored defined contribution retirement plan under section 401(k) of the Internal Revenue Code (26 U.S.C. § 401(k)) in the United States, and some other countries. A 401(k) plan allows a worker to save for retirement while deferring income taxes on the saved money and earnings until withdrawal. The employee elects to have a portion of his or her wage paid directly, or “deferred,” into his or her 401(k) account. In participant-directed plans (the most common option), the employee can select from a number of investment options, usually an assortment of mutual funds that emphasize stocks, bonds, money market investments, or some mix of the above.

Riiiighht. And now I know a 401(k) has something to do with income taxes, mutual funds, company stocks, bonds, and… participant directed trustees? Since when does this qualify as a definition?

I am going to spare you the gory details of my journey into the depths of the retirement. It was long and frustrating. In the end, I did figure it out what a 401(k) as well as why it is so very important to start saving for those elderly years at a young age… yes, everything they say is true. Saving for retirement is very important, so important, that you should stop what you’re doing and start today. And trust me, I am the last person to jump on the saving bandwagon; when someone attempted to describe it’s merits to me, “if you contribute to a 401(k) you will be rich” my reply was, “Yeah, ok. Rich when I’m OLD”.

So, today I am going to breakdown exactly what a 401(k) is. Please let me know if I am missing anything, this is all information I have gathered from blogs, investment banking websites and calling a lot of investment banks and having very, very long chats with the people they pay to know this stuff and answer your questions. A special thanks to Ben at Fidelity, and Mike at Vangaurd. Yup, true story, companies like Fidelity, Schwab and Vangaurd all pay people to sit by phones and answer all your questions about money. They’re very nice and will talk to you as long as you like. I really think you should try this.) In my next post, I am going to talk about why, beyond the evidence presented below, saving for retirement at a young age is a really smart things to do.

A 401(k)’s 411:
A 401(k) is a way to save for retirement. It is not an account in itself but a plan that offers different ways to save the most money possible over a long period of time Because the stock market is the biggest long-term money making machine out there, most 401(k) plans offer you a range of ways to save in the stock market. These varying ways to save are thus called investments and come in forms like mutual funds, bonds, stocks and money market funds (more about these terms later).

401(k)’s are generally available through your work, this is why they’re called employee-sponsored retirement plans. All this means is that your company has a general 401(k) plan that they offer to all their employees. The federal government created these plans for businesses back in the eighties as an attempt to get the most people possible to prepare for retirement.

The money you put in your 401(k) is taken out of your paycheck before it’s slapped with taxes. This one of the reason’s that people get so friggin’ excited over the 401(k). Here’s why:

Let’s say you make $2,000 each paycheck. If you put 5% of your check, that’s $100 into your 401(k), then you only pay taxes on $1900. This means two things.

1. You pay less in taxes.

  • If you’re making $2,000 and are taxed at 25%, then you pay $500 each paycheck in taxes. Yes. I had the same reaction.
  • If you contribute $100 of your $2,000 to a 401(k), you are only taxed on $1900, meaning you only pay $475 in taxes.
  • So, by contributing $100 each paycheck you not only save $25 in taxes, but come April 15, you pay taxes not on $48,000 (your salary if you make $2,000 twice per month) but $45,600 salary.
  • This also means that extra $100 you stashed away each paycheck, is growing, free of taxes and this brings us to part two.

2. You don’t pay ANY taxes on the money you contribute to your 401(k).

  • Let’s say you plan to save $100 but in a savings account or CD account. If you’re taxed at 25%, that $100 is really $75. Meaning you actually only have $75 to invest. However, if you put $100 in a 401(k), it’s not taxed, meaning you have a full $100 to invest.
  • Over time, that extra $25 makes a really big difference. Check out this graph by Ramit of http://www.iwillteachyoutoberich.com, to see just how big. Ramit writes a very good guide to retirement, called “The World’s Easiest Guide to Understanding Retirement”, see it here.
    Tax-deferred vs. Taxed

The difference between the blue and orange bars, is the difference between a taxed savings account and a non-taxed savings account, (i.e. a 401(k)) add a significant interest rate to this… and wholey moley… imagine the possibilities.

The Other HUGE advantage to a 401(k): The Company Match

If you put money in your 401(k), there is a chance that you’re company might also put money in your 401(k). This is called a company match. This means that for every dollar you put into your 401(k), you’re company will contribute a dollar to your 401(k), up to certain point. This means if you’re saving $2,400 per year, and your actually saving $4,800 per year. To find out if you’re company has a matching program, talk to your HR or admin person.

So essentially, by contributing a small amount of money per month into a 401(k), you are:

1. Saving more money than you could anywhere else because the money you put towards a 401(k) just grows and grows without being taxed. It is however, taxed, upon withdrawal.

2. Paying less in taxes per year but still making the same amount of money. Remembering our example above, even though your still making $48,000/year, you’re only paying taxes on $45,000 of it, so you’re actually saving more money.

So this is the basic breakdown. Obviously, if you save in a 401(k), you can save a lot of money. Again, let me know if I am missing anything… this is my first pass. Tune in next time as I discuss why it’s worth it to save money that you essentially can’t touch for a very long time…

7 Responses to “The 411 of the 401(k)”

  1. Jason Says:

    Keep in mind that although you don’t pay taxes on the money before it goes into your 401k, you do pay taxes on it later when it comes out. When you really start to consider your retirement planning, you want to keep that in mind. There are ways to reduce your retirement tax burden, for example: have some amount of post-tax investment, such as a Roth IRA (that’s another retirement tool you should research).

  2. kat Says:

    What a great article, thanks! I’m a retirement newbie too. I *did* contribute enough to get the employer match at my last job, but that’s as far as I got.

    Now I’m at a job that doesn’t offer matching (we have a pension plan, so the 403(b) — which is, afaict, the same thing as a 401(k), only for educational institutions — is on top of that).

    What I would really love to see is a rundown of Roth IRA and how it compares. I think I read somewhere in a Groups discussion that, if your employer doesn’t offer matching, Roth IRAs are better, but I don’t know why.

    The tax thing confuses me too. If you’re paying the tax on them eventually anyhow, why does it matter if you pay it before or after? In fact, why is it even better to put off paying taxes on that money? To put it another way… isn’t it better to pay before (and get taxed on $100) than to pay after the investment has grown to $1000? I mean, wouldn’t you end up paying more?

  3. Dave Says:

    Nice article. Next you might tackle the fees to look out for when picking funds within your 401k. My company offered 10 funds with 8 having load fees above 2%. Many times companies aren’t offering great options in thier plans so it’s something to be aware of.

  4. Jason Says:

    @kat

    With regard to taxation of 401k and Roth IRA, my understanding is that it has to do with your income bracket. You want a balanced tax picture when you retire so as to minimize the amount of taxes you have to pay. When you’re young, it costs a lot to live. Your car and home are not likely paid off, you have expenses for children and commuting, etc. etc.

    When you’re older, you can live on less money. At the same time, your taxable income is lower as you’re drawing a portion of your income from your Roth IRA (which is post-tax investment). So, you’re only paying taxes on your 401k withdrawals.

    I’m not an accountant, an advisor, or a tax-professional. This is just my rough understanding.

  5. Women of personal finance spotlight: Allese Thomson from Wesabe here to answer your questions Says:

    […] The 411 of the 401(k) […]

  6. Alexander Gieg Says:

    Sorry to nitpick, but please take care with the difference between “your” and “you’re”:

    a) “invest you’re money” – I *AM* not money, I *AM* a person.

    b) “that you’re company” – Neither *AM* I a company.

    Remember: “‘re” is a contraction of “are”.

    Other than this: nice article. I’m not American nor living in USA, but it’s very interesting to know how banking works over there.

  7. The Wonders of the Roth IRA « Wesabe: Your Money. Your Community. Says:

    […] Wonders of the Roth IRA By Marc Hedlund In August, I wrote a post detailing the benefits of the 401k, one of the best ways to begin building wealth at early age. The other? The Roth IRA. Like the 401k, […]

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