What is a 401(k) anyways, and why should I care?

Retirement
KJ: Forty years ago, 401(k) plans didn’t even exist. In the days of our parents and grandparents, the primary source of retirement income came from pension plans. They provided families with retirement income similar to how Social Security functions (and often times private pensions could extend to the surviving spouse or heir).

Retirement Income Sources Are Changing
Nowadays, pension plans are not usually available for most employees. In fact, traditional pension plans covering employees have declined to only 20% of private workers over the last 30 years(1). Times are very different. Employees do not stay at the same firm for their entire 30+ year career. Since employees change jobs frequently, corporations began to shift retirement income funding on the responsibility of the individual. In prior generations, individuals – take my grandpa for example – worked at a company for decades, retired in their mid-60’s, and then lived for another 20-30 years to age 95! That’s a long time in retirement for any pension plan to sustain. Due in part to changing demographics from increasing life expectancies and declining average years at an employer, the modern-day 401(k) became popularized.

Take Responsibility and Contribute Today
What it boils down to is if you do not participate in a 401(k) plan, but you have access to one, you need to be contributing! If you aren’t, then you may have no other source of retirement income and assets other than Social Security – whatever shape or form Social Security takes over the next 20+ years.

Some people describe that they cannot afford to contribute to their 401(k); the reality is you cannot afford to NOT contribute to your 401(k) if you ever have a desire to retire or scale back from work. At a minimum, you should be putting away at least 5% in your 401(k) at work. The IRS allows an employee to contribute up to $17,500 per year (for 2013) and up to $23,000 if you are older than 50.

Unfortunately, some people get bogged down by the lingo of it all that they do not realize they are leaving money on the table by not contributing to their 401(k).

Employer Matching Opportunities
One of the greatest features about 401(k)s is that most companies offer a matching opportunity. If you contribute a certain amount of money, then the employer may match part (or all) of the contribution. There’s no better way to get an instant 100% return on your investment and savings!

    Illustration: For round numbers, if your family makes $50,000 per year and puts 5% into a 401(k) with the employer matching 4%, that means after one year you would have saved $4,500, and after five years you would have saved $22,500 (without including any type of investment growth!). In reality, if you had saved this money in another account on your own, then you would have only put in $12,500 of your own money: that’s only 56% of the 401(k) amount with the employer match.

    If you factor in an average investment growth of 5% per year, then with the employer match you would end up with $24,865 while saving your 5% on your own would result in $13,815 – a difference of $11,050.

AJ: Long before 401(k)s were cool my dad was singing their praises. As a manager in a major corporation in the 80s he saw how rapidly employer-funded benefits were decreasing and was desperate to help his employees make better choices for their families and their future. Kirby’s numbers above speak for themselves and I am sure those people who worked for my dad that didn’t heed his advice are kicking themselves every single day about it. If you truly can’t afford to put 5% of your income aside, consider getting a once-a-week part-time job to make up the difference and allow you the opportunity to save for your future. It is negligent not to find a way to leverage such an incredible opportunity to earn free money.

Your contributions are YOURS
KJ: The best thing about a 401(k) is that all the money that you put in yourself is yours to take whenever you leave the company whether by choice or other circumstances. Typically, you can then roll over the 401(k) into a new 401(k) with your new employer or you can roll over the funds to an IRA (e.g. at Schwab, Fidelity, TD Amertirade, Scottrade, etc.). In many circumstances, the contribution the employer makes to the 401(k) may have most – or all – of the contributions from the employer rolled over when you leave(2).

Taxation
A Traditional 401(k) is deductible on your current year income taxes. Sure, you still have payroll taxes that are assessed (7.65% – 6.2% Social Security with 1.45% Medicare), but you save on the current year’s income taxes. A Traditional 401(k) is particularly beneficial if you expect to be in a lower tax bracket in retirement with little income sources other than Social Security. Keep in mind that it’s not just a consideration of what current tax rates are, but rather an expectation of what future tax rates may be since today’s tax rates are near historical lows.

Roth 401(k)
If you’re one of the fortunate few, some 401(k) plans allow you the option to put money in what’s considered an “after-tax” 401(k) (i.e. a Roth 401(k)). This means that you pay income taxes in the current year on the contributions, but you don’t have to pay income taxes on the earnings/growth in the future when you take money out of the account (under certain age restrictions per the IRS). The Roth feature can be very attractive for younger individuals saving for retirement where they may be in a much higher tax bracket in their later years of life. It can also be a great way to get funds in a Roth-type account if you and your family can no longer contribute to a Roth IRA due to income limits.

    Do you have a 401(k) at work?
    Does your employer provide a matching contribution?
    Do you maximize your 401(k)?

For more information comparing a Roth 401(k) to a Traditional 401(k):

(1) Social Security website
(2) Note: Some plans have rules and restrictions of how long you have to have worked with the company based on a “vesting schedule” and how much of the employer’s contributions are yours.

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2 thoughts on “What is a 401(k) anyways, and why should I care?

  1. Starting early is the key. You leave so much money on the table by delaying 401k contributions, especially with employer match. it’s hard trying to convince young people to start contributing to 401k because they have a harder time preparing for something that is 40-50 years away.

    • Lots of young people have trouble contributing to their 401(k) because they think retirement is so far away. The reality is, the sooner you start contributing, the better off you will be long-term, so retirement can actually be a goal that you can accomplish. Especially if you have an employer match, you’re just leaving free money on the table! If you don’t start learning good savings habits when you’re young, then you can’t expect that you will miraculously begin to save appropriately later in life.

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