This blog post is all about what a 401k is and how it works
401k’s can be very confusing!
Are you leaving your current job and wondering what you need to do with your current 401(k)?
Nervous that you requested a rollover check and now you are going to have to pay taxes on all that money???
Maybe you just called Wells Fargo, The Standard, Millennium Trust (why is this company so difficult to deal with??) or some other company and you’re so confused with the paperwork and you are thinking you are better off just leaving it alone.
Today, you will learn what a 401k is, how a 401k works, how much money you can contribute, what the heck the match means and what the vesting is.
You will also know exactly what your 401k options are when you leave your current job as well as the exact steps to take if you want to rollover your account elsewhere.
If you make it all the way through, you’ll get the answers to some questions that come up ALL of the time with our clients.
Let’s dive in.
This blog post is all about what a 401k is and how it works
What is a 401k?
As you know, I like to take super complicated topics and make them a little bit less, less complicated basically.
A 401k is defined by our good ol’ friends at the IRS as a defined contribution (fancy word that means YOU contribute too, not just your employer like in a pension) plan that is tax-advantaged.
The bottom line is that a 401(K) is a retirement plan established by an employer to allow employees to contribute towards their retirement via payroll deductions and have their contributions invested. This is the #1, most common way that the average American participates in the stock market
The payroll deductions can start happening automatically (if you are on here because you are pissed that your employer didn’t even ask you before they started deducting from your paycheck, you can thank the auto-enroll feature) or you will need to be eligible for and sign up for the 401(k) plan for your contributions to start.
The reason the IRS called a 401(k) plan tax-advantaged is that you technically get a tax-deferral on the yearly investment growth of the funds up until you choose to start withdrawing your money.
You can also get a tax deduction now (traditional 401(k)) or later (Roth 401(K)).
Lastly, you COULD get a portion of your account completely tax-free if you have the Roth 401(k) option and you use that.
*The IRS is also to blame for the horrible horrible names: 401(k), Roth, etc. 401(k) is just the section of the tax code that makes these plans possible, and Roth IRA’s & 401(k)’s are named after William Roth.
He is the senator that came up with the idea of letting people pay taxes now instead of later via the creation of the ROTH IRA. The Roth IRA did really well and eventually, the concept was adapted to a lot of 401(k)’s too.
What is the difference between a 401k and a Roth 401k?
You want to know the main difference between a 401(k) and a Roth 401(k)??? TAXES!
Isn’t the answer to every bad question always taxes? Sure is!!
Do you want to pay taxes now or later?
That is really the main question to ask yourself. Although the answer is not so simple right.
The reason most clients need me to walk them through that decision is that we have NO idea what taxes will be like in 10-30 years but we DO know how much we want to use our money today.
All those fun things we want to do.
Your competing life goals are also, competing, for every single dollar on that paycheck.
Paying off student loan debt or paying down your mortgage, saving for a house, a wedding, your pet’s vet bills are stacking up, I get it.
If you choose the traditional or pre-tax 401(k) option, you get a deduction and taxes and so your take-home pay doesn’t get reduced as much as if you go with the ROTH 401(k) option.
More money for your other things today. Isn’t that what every human wants?
Money now, things now!
But maybe after reading this post, you realize that’s not the best option for you or your family after all.
Money affects every aspect of our lives. Oh, I’m sorry if you are reading this and this is your first job! I don’t want to burst your bubble, but yes money does peek its head into EVERY corner of our lives.
Traditional or Pre-Tax 401k plan option
The traditional option allows you to contribute part of your salary towards your 401(k) while simultaneously receiving a tax deduction on that contribution.
Let’s make sense of this with some numbers.
Your salary is $50,000
You contribute 10% of your salary to your traditional pre-tax 401(k).
That is $5,000 from your salary.
Let’s say you get twice a month. 24 times a year.
That means that every paycheck you will be contributing $208.34 towards your traditional 401(k).
Let’s also assume that you are married filing jointly and your spouse doesn’t work (for sake of simple math).
So your checks would look like this:
-$208.34 (traditional 401(k) contribution, 10% of salary)
= $1,650 TOTAL TAKE HOME PAY
The money that you are contributing to your retirement basically lowers the taxes you pay today.
Why would someone choose the traditional 401k option?
Maybe you feel like you would rather get a deduction today because your income is so high that you don’t qualify for any other deduction.
Maybe you need every dollar that you make and it is already a sacrifice to make a contribution to a 401(k) plan
Roth or Post-Tax 401k plan option
Now on the flip side of the traditional 401(k) option, you will find…the Roth or post-tax plan option.
This option allows you to contribute to your 401(k) plan after you have already paid taxes on your full salary BUT you don’t have to pay taxes on the money when you withdraw it in retirement.
Let’s get back into the numbers to help you visualize the difference.
Again, your salary is $50,000
You want to contribute 10% of your salary
You get paid twice a month. 24 times a year.
So your checks would look like this:
-$208.34 (Roth 401(k) contribution, 10% of salary)
= $1,625 TOTAL TAKE HOME PAY
You can see that the Roth 401(k) option means that you pay $25 more towards taxes every paycheck in our example.
$25 a check, $50 a month, $600 a year more on taxes today with our $50,000 salary example.
Maybe you feel like since you know exactly what taxes are today, you would rather pay the taxes now and use the ROTH 401(k) plan option to make sure that you don’t have to pay taxes in the future if taxes go up.
I should also say this now: Is it possible that you don’t have a ROTH 401(k) option in your retirement plan. Your employer is the one that makes the decision to allow a 401(k) Roth feature into your employer-provided retirement plan.
If the employer has been offering a 401(k) plan for a long time, you might not have a Roth 401(k) option because well, that option has not been around THATTT long so they likely haven’t updated their plan document.
If you work for a new company or a company that just started offering a 401(K), they are more likely to offer the Roth 401(k) option.
Whichever option you choose, you do not have to pay any taxes on your 401(k) growth (the balance increase based on your investments going up). If you withdraw money before you are 59 ½ read those rules below.
As Certified Financial Planners, we use a mix of indicators to give every client the best possible advice. The decision is not one size fits all. Age, income, family dynamics, and personal preference have to all come together.
What is the maximum 401k contribution?
The amount of money that you can contribute to a 401(k) depends on your age and it changes almost every year when the IRS updates the contribution limits based on inflation.
Just to complicate things, you might hear the contributions referred to as “employee elective-deferral contributions.”
That just means that you as an employee are electing your deferral (tax-deferred) contributions.
That keyword: tax-deferral tells you exactly why there is a limit on your contributions.
The IRS wants to get what they are “owed” on the money they earn.
If they allow you to defer taxes on some of your income, they will cap how much you can defer. Because of course, they will.
*Your employer’s 401(k) match does not count towards the limits below*
The 2021 limits are as follows.:
Employee contribution limits:
Prior to age 50
$19,500 a year
After age 50
$19,500 a year plus a $6,500 “catch-up” contribution.
Yes, you are allowed to catch-up and defer more when you are older.
Because that tells the IRS that you are THAT much closer to having to retire and THAT much closer to…paying any taxes that are due.
They will let you defer taxes on a few more thousand dollars for a few more years.
Your employer may choose to contribute a matching contribution to your 401(k).
An employer match is like free money. You receive it as an incentive to participate in your retirement plan.
Your employer can match none of your contributions (no match) or they can match 100% of your contributions (looking at you amazing companies that match 100% of employee contributions. Good for you!!)
The most common matching contributions are the following:
100% of the first 3% of employee contributions.
100% of the first 3% and 50% of the next 2% of employee contributions. (Totaling a 4% match)
100% of the first 6% of employee contributions.
It is super important to know 2 things as it relates to your employer’s 401(k) match.
1.Just because you have only contributed to the Roth 401(k) option, does not mean that you will not pay ANY taxes when you withdraw money from your 401(k).
If you have an employer match, your employer is receiving a tax deduction for that match and so you are responsible for the taxes on that “free” money.
2. If you are one of the people that want to “max out early” because you want to take advantage of being fully invested as soon as possible, you will want to verify with HR that your company does a “true up” match at the end of the year.
This means that even if you contribute the $19,500 or the full $26,000 by say, September, you wouldn’t be missing out on any matching contributions that would normally happen in October, November, and December.
If you don’t know how much your company matches your 401k contributions, you will want to reach out to HR or your payroll department and ask them what it is. You can (and should) also ask for your 401k plan summary so you can also be aware of the vesting schedule.
Now you are wondering what a vesting schedule is.
I am glad you asked.
What is a 401k vesting schedule?
A vesting schedule is the length of time that you have to be employed with your employer for you to take the matching contributions that your employer makes if you were to leave your job.
This sounds simple but there is a lot of confusion around it so let’s break it down.
Your employer might include a vesting schedule that says you are automatically entitled to the matching contributions that they make.
That would be extremely generous.
It is also very rare.
The most common scenario is a 6 year graded vesting schedule.
All that means is that you will gradually become 100% vested after 6 years of being employed with the company.
A 6-year vestige schedule looks like this:
After year 1 you are 0% vested in the company match
After year 2 you are 20% vested in the company match
After year 3 you are 40% vested in the company match
After year 4 you are 60% vested in the company match
After year 5 you are 80% vested in the company match
After year 6 you are 100% vested in the company match
Going with the 6-year vesting schedule, let’s say you quit your job after being there for 4 years.
Let’s assume you end up with a total balance of $10,000 matching contributions throughout the years.
When you leave, you can take 60% of that $10,000 or $6,000. You would have to leave $4,000 behind because that’s the vesting schedule they have in place for their 401(k).
Let’s now assume you work for a tech giant in Silicon Valley and they instead have a 2-year cliff vesting schedule.
That simply means that prior to being with the company for 2 years, you get none of the match if you leave your job.
That cliff though!
If you make it past year 2, you get ALL of the matching contributions if you leave your job.
Moral of the story: Vesting schedules only impact you if you have a match and if you leave your job.
Please ask for that vesting schedule ASAP.
How and when can you withdraw your money from a 401k?
Technically speaking, you can withdraw your money any time but there are penalties and taxes involved if you are not doing a “qualified distribution”
There are a few events that trigger a “qualified distribution” from a 401(k) but the most common one is you turning 59 ½ years of age.
That is the magic age for retirement plans.
Prior to 59 ½ years of age
If you withdraw money before you are 59 1/2 years old, you would have to pay a 10% penalty for withdrawing early.
You would also have to pay taxes if you are withdrawing money from your traditional/pre-tax 401k plan.
The taxes due would be based on your total income the year you withdraw the funds.
If you made $100,000 in 2021, and you withdraw a total balance of $200,000 then your total income would be $300,000. You would pay taxes according to that total.
If your 401k contributions were made to the ROTH 401k option, you do not have to pay any taxes on that portion.
After 59 ½ years of age
If you are already 59 ½ years of age, you would not have to pay the 10% penalty anymore.
You would still have to pay taxes on any amount withdrawn except for any ROTH 401k contributions that were made
As of 2020. the latest you can wait to withdraw your funds is 72 years of age.
The IRS calls those RMD’s or required minimum distributions.
If you turned 70 ½ prior to 2020 and had already started your RMD’s, you can’t stop taking them. Sorry!
If you are still employed at 72, you can keep contributing and you don’t have to withdraw anything until you stop working.
What are my 401k options when I leave my job?
1.Leave the money at your current (soon to be previous) employer
You actually are able to leave your funds where they are currently at. Your previous employer benefits from having your funds stay there because a larger 401k balance leads to lower plan costs.
If you have over $5,000 in your current employer’s 401k plan, they usually won’t attempt to reach out to you.
If you have between $1,000 to $5,000 in your current 401k plan, the plan provider will usually send you a letter and ask if you want the money rolled over into an IRA that they have set up for employees who leave.
If you don’t answer they could automatically roll over the funds.
If you have less than $1,000 in your current 401k plan, they could actually automatically send you a check for the balance.
In any event, most people don’t remember to roll over their funds so they simply end up leaving it where it is.
That doesn’t mean it’s the best choice though. Your current 401k plan might have higher fees associated with it.
It might also have lower-performing funds.
You have to look at all of your options to make the best decision.
Rollover your account to your new employer’s 401k plan
You can also roll over your account to your new employer’s plan.
The steps to do that are listed below.
A 401(k) rollover can take 7-30 days depending on the rules around your current 401k plan. They could require pre-authorization by HR before they release the funds.
That can be cumbersome but it’s not too common.
Usually, you see this with hospital employers.
If your new employer offers a retirement plan with lower fees and better-performing funds, you might be better off rolling it over.
Rollover your account to an IRA somewhere else
Let’s say you have an IRA elsewhere and you might want to have your funds invested in funds that are not offered at your new employer, in that case, you can roll over your funds into an IRA.
You might also want to start working with a financial advisor as you decide to get more help with your finances. Your advisor would manage your IRA so you can roll over the funds there. For example, my clients specifically would rollover their 401k to an IRA at Fidelity that I manage for them because that’s the brokerage institution that our company uses. Yours could be different or it could also be an IRA at Fidelity.
The rollover process would be the same as the process to roll over to a new 401(k) except the new account information would be provided by your advisor or by the online financial institution where you hold your IRA.
Cash-out your account
It is an option, but it is usually never the best option if you are not ready to retire.
Especially if you are under 59 ½
In the event that you really need the funds due to an emergency or a disability, you can of course request your funds.
You would be sent a check.
You are also given the option to withhold taxes or to not withhold the taxes and just pay them at tax time.
The choice is yours.
What are the rollover steps if I choose that option?
- Call your new employer’s retirement plan provider (HR if you don’t know who manages the 401(k) yet) to get the website, phone number, etc. of your new plan provider so you can create an account online.
- Call your previous employer’s retirement plan administrator (usually a 1-800 number) and request a rollover. You will need the information you received from your new employer. Specifically, the name, address, and account number of your new 401k retirement plan.
- Mail the rollover check into your new retirement plan provider or verify that it has been processed if the rollover was sent directly to the new company.
- Invest your funds according to your risk tolerance
Anything else I should be aware of?
Are 401(k)’s a scam?
401(k)’s are not a scam. I do see those videos and blog posts circulating the internet though and I do know some people talk about them as if they are a scam.
From my experience, working with thousands of people throughout the years, if you experienced 2008, and you withdrew your 401k money during the crash…
You are convinced your money was cut in half.
That doesn’t mean 401(k)’s are a scam. That means your advisor or your HR admin or whoever was supposed to explain the plan to you, failed to do so.
You do not want to withdraw your money simply because the market takes a dip.
That’s a bad idea.
That’s also a whole other post that I will have to publish at a later time.
Are 401(k)’s worth it if I am not given an employer match?
This question gets asked so often!!
The answer is honestly, it depends.
It depends on your ability to be a disciplined saver.
It is a lot easier to have money automatically withdrawn from your paycheck for your retirement contributions to take place than it is to remember to contribute to your IRA.
Yes, you can set up automatic contributions to your IRA on a regular basis (my clients use this technique) but it is still not as simple as a 401k contribution.
However, your 401k is limited to what your employer decides to offer as far as investment options go.
If you are not too confident in your employer’s decision-making abilities, you don’t think the plan is looked at often to weed out high fees, or you simply don’t feel like you want to participate, then an IRA is great too.
Just keep in mind that an IRA has much lower contribution limits.
The IRS also limits your ability to deduct pre-tax IRA contributions if you are offered a 401k at work.
The government’s way to encourage employees to contribute to their 401k first.
Again, another post.
What happens to outstanding loans if I am fired or I quit?
This one is painful.
If you are fired or you quit your job, but you have an outstanding 401k loan balance… the IRS says:
“a loan that is not paid back according to the repayment terms is treated as a distribution from the plan and is taxable as such.”
Yes, you guessed it. Taxes and penalties may apply.
I received a check but I never requested a rollover!
You probably had a balance smaller than $1,000 so your previous employer was able to just send you a check.
I know, it’s kind of crazy that they can just do that. But they don’t want to deal with the administrative costs.
I wish I could say that was a bonus for being a great employee.
Although many people do believe that’s what that is and they just go ahead and cash it.
Then they are reminded at tax time that they now have to pay taxes and usually a penalty as well.
Yes, for being under 59 ½.
Such is life folks.
Not always fair but I am here to share my knowledge and help you make the best decisions for you.
As always, if you have any questions feel free to reach out to us here
Happy to help!!