How much do you really know about 401k? I promise you will improve your 401k literacy after reading this.
“The question isn’t at what age do I want to retire, it’s at what income” George Foreman
A word is enough for the wise.
Retirement age might be 65 years old, but are you ready at that age? Will you have enough at that age? If you cannot answer that question, then don’t even think of retiring early.
Thankfully, there are many tools out there to help us with retirement.
One of the confusing parts of finance is the way the number and alphabets come together. It’s like speaking another language. So learning about them is also like learning a different language. Learn the language if you want to improve your financial competencies and thus your overall financial outlook. We have numbers – 401k, 403b, 457, and 529…. We have the letters – Roth IRA, SEP IRA, NQDCP… Then the combinations like Roth 401(k), SIMPLE 401(k).
In this post, we are going to zone in on the 401(k) plan.
This post is most relevant to people living in the United States. However, you can follow along for interest sake if you are from other countries.
Before we get started, I would like to introduce you to the background history of 401k.
Table of Contents
WHAT IS 401(k)?
First, don’t get carried away by the bracket thing in the 401(k) = 401k = 401K.
Since IRS is the one that comes after you if you try anything shady with your taxes. I figured their definition should be at least true.
401K definition according toIRS
A 401(k) is a feature of a qualified profit-sharing plan that allows employees to contribute a portion of their wages to individual accounts.
- Elective salary deferrals are excluded from the employee’s taxable income (except for designated Roth deferrals)
- Employers can contribute to employees’ accounts.
- Distributions, including earnings, are included in taxable income at retirement (except for qualified distributions of designated Roth accounts).
The quick and dirty version of the definition – In the traditional version which pertains to most people – This is a type of retirement plan which allow contribution of pretax money. The pretax money enjoys a compounded growth over time. You pay the tax when you withdraw it at retirement. You are penalized if you take it earlier.
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Here is a video on 401k to break the monotony.
HISTORY of 401k
401(k) has not been around for that long actually. Perhaps I am showing my age.
401(k) is actually an Internal Revenue Code. Congress passed the Revenue Act of 1978, which includes a provision that allows employees to avoid being taxed on a portion of income that they decide to receive as deferred compensation, rather than direct pay.
In 1981, the I.R.S. issued rules allowing the funding of 401k plans through employee salary reductions.
Since then, there have been many revisions to the 401k. An interesting fact to know is that there was a point in time when you can contribute up to 30,000 dollars into your 401k.
This year, 2019, the limit is 19,000 dollars. Check out our post on the new changes for 2019. It is a no-nonsense quick review. You want to be up to date at all times when it comes to money and the IRS.
There are many more exciting facts that I found about 401k from my readings but the brief history should suffice for the purpose of this writing.
Ok we get it! 401k is awesome. Click To Tweet
But do people actually take advantage of it enough?
Some statistics will help us
Americans’ average 401(k) balance released at the second quarter of 2017 is $97,700.Only 32 percent of Americans are investing in 401kaccording to the U.S. Census BureauAccording to a personal capital study, only 21% of Americans max out their 401kThose statistics are not encouraging. The more I looked into it, the more surprised I become. So I will stop there. Take advantage of this benefit. They call it “benefit” for a reason.
Check out our article on the time value of money to see why you need to invest now rather than later.
Maybe I will do a post about interesting or crazy statistics about 401k in the future.
Types of 401k
There are many types of 401k plan. Listed on the IRS website are
- Traditional 401k
- Safe harbor 401k
- SIMPLE 401k
There are two other 401k plans that are important to know
- Solo 401k and
- Roth 401k
Let’s discuss each one of those in a digestible manner. If you are not confused when reading the above types of 401k, then you are already a pro. Go ahead and skip to the end and leave a comment.
Traditional 401k plans
This is the type that most of us will be dealing with. This plan allows eligible employees to make pre-tax elective deferrals through payroll deductions.
In addition, employers can make contributions on behalf of all participants – This is what we commonly refer to as the “Match”.
This plan usually has a vesting schedule which means your employer can handcuff you with their match. For example in my current job, you can only take the match with you after 5 years.
You earn 20% of the match each year. Ask about your employer’s plan and how they match.
How much can you contribute to this plan? $19,000 as of 2019
If you are 50 years or older, you are in luck, you can pile on an additional 6,000 dollars making a total of 25,000
Both your contribution and the match cannot exceed $56,000. I have never heard of such a generous employer that will give you the maximum match (56,000 – 19,000 = 37,000). If you find one please message me, I need an interview ASAP.
Safe harbor 401k plans
This is similar to a traditional 401k plan, however, the employer contributions are fully vested immediately after the match. Your match is safe! That’s why they call it safe harbor.
How much can you contribute to this plan? $19,000.
The same rule applies as traditional 401k for people older than 50.
SIMPLE 401k plans
Close to the safe harbor 401k plan, the employer is required to make employer contributions that are fully vested. This type of 401k plan is used mostly by small businesses.
How much can you contribute to this plan? $13,000 – Major difference from the above
If you are older than 50, you can contribute 3000 dollars extra making $16,000 total.
Roth 401k
In this type, you contribute after-tax money. The only reason someone should ever contribute to this is if you are 100% certain that your future tax bracket will be higher than it is now.
How much can you contribute to this plan? $19,000.
Solo 401k
My favorite. Like the name implies, ‘Solo’, it is for businesses with no employees. So if you do a side gig and you are the only member, then you can do a solo 401k.
The reason I love this is that you can contribute the maximum on this one.
Here is how to achieve that. Contribute as an employer and then contribute as an employee. You can do this because you are both
Contribute $19,000 or $25,000 if you are older than 50 as an employee.
You can also contribute 25% of your compensation as an employer.
The total contribution possible is 56,000 dollars.
If you remember the catch-up contribution of 6,000 dollars more for people older than 50 years old, then you are following along.
The maximum contribution for participants older than 50 years old is $62,000.
If you have a regular job and you are paid by W2 and you have a side hustle with 1099. You can potentially contribute $19,00 to your W2 job, and then 25% of your compensation from your side hustle into solo 401k.
The solo 401k is one of my main reasons to have a side hustle. For physicians, it is mainly locum or moonlighting. For the non-medically inclined, moonlighting is exactly what it is. Working another job that is not your day job.
How can I open a 401k retirement account?
For those working and getting paid by W2, the only way to get 401k is through your employer.
If you work as an independent contractor or business, you can open it yourself. But that’s a different topic. My take is that if you are at the level in which you run your own business, you should already understand these concepts.
Every plan has some sort of target date retirement funds. You can start with that until your competency improves.
Target retirement funds are a pre-designed portfolio for retirement. This is how it works.
Start by finding what year you want to retire, let’s say 2050. Find a target retirement fund that says 2050, and then invest in it.
The beauty of this type of fund is that it changes the asset allocation from more risky ratio to less risky as you grow older.
For example, the 2050 portfolio right now will have about 90 percent stock and 10% bonds. By the time its year 2030, the mix will be closer to 80% stocks and 20% bonds.
In our post on how to survive a bear market, we touch base on asset allocation and how your risk level determines your asset allocation.
How can I take my money out?
401K Distribution rules
Here is where some of you can find the downsides for 401(k). Let’s go over the distribution rules by IRS and break it into easier chunks.
First, it is important to know the main reasons why your 401k will be distributed – aka will be paid to you.
- You die – well, I mean you don’t need a 401k retirement account at this time. You have done well saving for someone else. The distribution goes to your beneficiary.
- You become disabled – At this point; this is almost the same as retirement. You will need the money. IRS is nice to let you have it without penalty.
- Severance from employment –You can get the 401k, however, you will have to pay penalty if you cash it when you are less than 55 years old. The penalty is 10% extra tax.
- The plan terminates and no successor defined contribution plan is established or maintained by the employer.
- You reach age 59.5 years old. This is when the government really wants you to get your money.
- You run into financial hardship – You can’t just say hey! Uncle Sam, I can’t pay my credit card, can I have some money? Nope, not going to happen. Butif you say nicely, I was affected by the hurricane, can I have my 401k? You will get relief.
How can you avoid paying the 10% penalty before age 59.5?
The important ones that are likely to pertain to you are below. Check the IRS website for the full list.
- Made to a beneficiary (or to the estate of the participant) on or after the death of the participant,
- Paid because the participant has a qualifying disability,
- Made to a participant after separation from service if the separation occurred during or after the calendar year in which the participant reached age 55,
- Paid to a participant for medical care up to the amount allowable as a medical expense deduction
- As said above, if made on account of certain disasters for which IRS relief has been granted.
So you are leaving your job and you have 401k from that job. What can you do about the 401k?
- You can leave it in your old job. This is the easiest way out, however, some employer might not allow you to do that. Also, that employer may stop the plan at any time, leaving you scrambling for what to do.
- Roll it over to your new employer. This might be the best option if you have a new job already. If you don’t have a new job or your job does not offer a 401k, then you can do number 3
- Roll over to a solo 401k. To open a solo 401k, you just have to make a wage income that pays through 1099 (different tax document for independent contractors). If you make 200 box cutting laws, you can open with it. Then you can transfer the old 401k into it. Sleek right!
- You can roll over to “rollover IRA” of your choice. I don’t advise this one as it prevents you from doing a backdoor Roth IRA later.
Can you obtain a loan from your 401k?
Yes, you can. But don’t do it. Why would you want to do that? If you are borrowing from your 401(k), then you are defeating the purpose. That’s anti-wealth building.
You can do it though if you want to ignore the warnings.
If your plan permits it, you may borrow up to 50% of your vested account balance up to a maximum of $50,000. The loan must be repaid within 5 years unless the loan is used to buy your main home.
What is the difference between 401k and 403b
The short answer for those that just want it simple – Essentially the same in terms of how much you can contribute, match and withdrawal.
The main difference is that 403b is offered by public schools and tax-sheltered organizations.
What do you think? Is there something else you would like to know about 401k?
Adebayo
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I am a pulmonary and critical care doctor by day and personal finance blogger/debt slaying ninja by night.
After paying off close to $300,000 in student loan debt in less than 6 months into my real job, I started on a mission to help others achieve the same. There is no magic to this than to strap up and get it done. Some of the ways we achieved this include side hustle, budgeting, great negotiation skills, and geographical arbitrage.
When I was growing up, common knowledge in Nigeria is that there is one thing you cannot trust anyone else with, and you guessed it – your money.
Being frugal came easily to me based on my background. However, the concept of building wealth did not solidify in my mind until when I finished medical school. I wish I knew what I know now when I was 14. Still, I don’t know enough and I am constantly learning to improve my knowledge.
My goal is to reduce financial illiteracy among young professionals. I am catering to the beginners – babies and toddlers in financial literacy.
