So one of our readers asked us this question the other day: What is a 401k?
A 401k is a special savings account with three rules:
1. You pay much less tax on what goes into a 401k (and, if you want, don’t have to pay any tax at all on it until you take the money out).
2. You can only put up to $18,000/year into the account.
3. You can’t take the money out until you turn 59.5 years old (you actually can, but you pay a penalty that totally removes the value in putting the money there in the first place).
The program was created by the US federal government to incentive people to save for retirement. Typically you pay a percentage of each paycheck into your 401k, and most employers will match what you put in up to a certain percentage (usually 2-6% of your paycheck). Employers do this as a benefit; whatever percent they match can effectively be seen as a raise, which is pretty nice. You should start saving in 401K as young as you can do so reasonably. The earlier you start saving the more you’ll have for retirement.
401k plans come in two flavors:
1. Traditional 401k plan contributions reduce your taxable income. This is known as tax deferral – you are not taxed on the money you contribute now, but will pay income tax on your contributions and your earnings at your marginal tax rate when you take distributions from your 401k in the future.
2. If you contribute to a Roth 401k, contributions have already been taxed at your current marginal income tax rate. In exchange, all earnings may be distributed tax free if the distribution meets certain age and eligibility requirements. Note that not all 401k plans have a Roth option.
Which one do you choose? It depends on a lot of factors, but the big ones are:
1. Income – High earners are usually better off contributing to a traditional 401k, as this allows them to avoid paying their current high marginal tax rate. Conversely, those with lower incomes usually favor the Roth option, as they can pay a low marginal tax rate now in exchange for never being taxed on that money again.
2. Your guess about your future income tax rates – Those that believe they will be in a lower income tax bracket when they retire usually favor the traditional 401k. Those that believe they will be in a higher income tax bracket when they retire usually favor the Roth option. Those that believe income tax rates will rise across the board in the future usually favor the Roth option.
It is possible to contribute more than 18,000 a year. It is rare to get any of that money tax free in most cases they do not offer Roth 401k and even then to meet requirements for tax free are ridiculous I have a disabled guy that’s 88 and still has to pay taxes on his Roth IRA when he takes his RMD of only $200. They use the same guidelines. You also can get money out prior to 59.5 without penalties should you meet certain criteria typically circling around a bad financial, medical, educational or loss situation but also rare. These are actually horrible avenues for your retirement, the company contributes because they get a tax write off for it and whenever you make money they normally keep half or more of the profit. Even worse when you lose money your account is still charged a maintenance/management fee so that the company never loses money only you do. I have never seen, met, or heard of anyone that was able to retire on their 401k. That is why diversification is extremely important. A 401k should only be used to lower your income with a contribution no higher than what is matched by the company. Even then I have many ways to grow funds at a much faster pace with benefits and no penalties with complete security, guaranteed interest for life that is higher than any IRA or stock/fund available on the market. Please refer to the Knights of Columbus field agent in your area if you want to learn about a 401k and building your personal retirement. We are non profit, advice and guidance is free and we have no management fees or penalties or charges. We are non profit and work with the Pope.