Apr 28th, 2008
Working Backwards: What’s a 401(k)?
A 401(k) is an employer sponsored retirement savings plan that is common in for profit companies. Non profits have a largely equivalent plan known as a 403(b) and public sector employees often have the also largely equivalent 457.
Dollars contributed to the 401(k) plan are pre-tax [although there has recently emerged a "Roth 401(k) which allows the contribution of post-tax dollars allowing withdrawals past age 59.5 tax free], meaning the employee receives an immediate tax break which could be substantial. For myself, this tax break amounts to approximately 30%; if I was to invest the same amount of dollars post tax, I would require about 30% more earned income, meaning that the $15,500 I put away last year would take more than $20,000 in earned income. Contributions also grow tax deferred–no need to pay taxes on interest, dividends, or capital gains every year!
Contributions by an employee to a 401(k) plan are often matched by the employer up to a certain amount; for instance, for every dollar an employee contributes to the plan, the employer may also contribute a dollar up to a certain limit, typically 5%. That’s free money! Don’t leave that one unaccepted; it’s like your boss telling you they’ll give you a raise and your turning it down.
If you leave your employer, 401(k) plans can be rolled over into a traditional IRA without any tax penalty, which may give you a lot of flexibility in terms of what you can invest in. You can also roll an older 401(k) into a new one at your new employer, but this is more complicated.
401(k) plans tend to offer a choice of several different mutual funds; hopefully your plan allows you choices of passively managed, low cost index funds including the total stock market index, the total bond market index, international funds, and many, many others. I am fortunate in that our plan is managed by Vanguard, the king of low cost index funds, and we have a large selection of funds through them as well as other vendors.
Finally, when you are eligible to withdraw funds from your 401(k) without penalty at age 59.5, the money is taxed as ordinary income; if you are in a lower tax bracket than when you were working, you’ve made out like a bandit on your taxes. There are some circumstances under which you may be eligible to withdraw money from your 401(k) without penalty (but still with tax implications), such as a first time home purchase or for high medical expenses–check with your plan and your tax professional for details.
One controversial feature of a 401(k) is the ability to take a loan from them, for any reason. Avoiding this if at all possible tends to be the best idea–you lose your tax advantage when you do this! First, you will have to pay the loan back with post tax dollars (so much for the tax break contribution!), and second, you still have to pay taxes at the time of withdrawal, so you end up getting taxed twice on that money. It’s also less money to earn returns over time in your account.
All in all, however, I think the 401(k) is a great financial tool to save for retirement and if you’re not taking advantage of it, you’re leaving money on the table–and that’s not something many people can afford to do.
