The 411 on the 401(k)

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What is something a lot of people have but they have no idea of how it works? Car? Cell phone bill? Both are very good answers, but there is something out there that even perplexes the best personal finance minds. Today we are talking about the 401(k)! *cue scary movie music*

The 401(k) is one of the best retirement investment vehicles in the game. 401(k)s are simple conceptually; however, they are woefully misunderstood. And when you misunderstand something, you cannot get the full benefit of it. DIAR is here to help you gain understanding so you’re ready to make the most of your 401(k).

What is a 401(k)? Here is the super stuffy definition: a qualified employer-sponsored retirement plan where employees make tax-deferred contributions from either their pretax or post-tax wages. That is a mouthful eh? Let’s run that through our super secret DIAR decoder. A 401(k) is a retirement plan that offered by your employer. The contributions you make are not taxed at the moment. They will be taxed upon withdrawal.  The deferred taxes plus the compounding make the 401(k) a super strong way for workers with a longer horizon to be quite comfy in retirement.

I’m sure you caught a word that you’re scratching your head over: match. If you read over the benefits package literature from your employer, there is a good chance you’ll see something like this: “ZYX Corp offers a 3% match”. All this means is that your company will match dollar for dollar up to 3% of your salary. Watch the math math really quick.

Your annual salary is $60k. Your employer, ZYX, offers a 3% match. Because math (60000*.03 = 1800), your employer’s maximum contribution to your 401(k) will be $1800. This is FREE money IF you chip in your 3%. My rule is always contribute at least the match amount. If your employer offers this kind of match…TAKE IT!!! Don’t leave money on the table. Now if you’re all industrious and want to contribute more, then expect to see that come directly from your net earnings.

My last line lends to a nice segue. There are maximum individual contribution limits for 401(k)s. Government had to put something in place because there would be nothing stopping some folks from dropping mad ducats that couldn’t be taxed immediately. At the time of this posting, circa May 2019, the current maximum limit was $19,000. For my over-50 Duc-Hunters, the max is $25,000. Again: these are the individual contribution limits. These limits do not include your employer’s match. If you’re curious to know the max max, then I’m glad to satisfy that curiosity. The complete, not a drop more, maximum is $56,000 OR 100% of your salary, whichever is less. We’ll talk more in depth about if/how you should max out contributions.

While all the aforementioned things are dope, my favorite benefit to a 401(k) is the investment options and flexibility. Now mind you, most plans will have a set list of investment vehicles to choose from. I cannot say this for all plans, but some that I have had in the past, allowed for self-investing. This means one could invest in any investment product. I knew quite a few folks who squandered their 401(k) trying to actively trade. I do not recommend this for most investors. I call this a Michael Jackson move. Since most of us can’t dance like Mike, let’s stick to your uncle’s two step and stay within your plan’s lane.

Before I go any further, hear this…you have to tell your 401(k) money what to do. Meaning if you do not invest in any funds, your money will sit there in a most like a money market account. Money markets will make some ducats (think 2% or so), but it will pale in comparison to the average market return of 5 to 8%. Simply put: I’d rather you close your eyes and pick a random fund than to let your money idle away in a money market. Someone once told me a story about a woman who worked at a company for years. She invested in her 401(k) faithfully. One day a co-worker was making small talk about some new funds the company’s 401(k) offered. She looked at the co-worker with a puzzled look on her face. PLANS!?! /end Soulja Boy voice…the poor woman did not know she had to allocate her money. Did she have more money than she put in? Sure. Did she as much as she could have? Nope. Don’t be that woman.

What can I invest in then? Each plan will be different. Some employers offer a litany of funds; others just a handful. The way you should approach your investments is based off a little thing called asset allocation amongst the different investment types. For 401(k) simplicity sake, we’ll stick to the big 2: stocks and bonds. I won’t go into the various subcategories of each in this article, so you’ll have to trust me.

How do I determine my asset allocation? There is an oldie but goodie that I absolutely despise but I’ll give it to you any way. Subtract your age from 100. That is the percentage of your portfolio that should be in stocks (also known as equities). The rest of the percentage should be in bonds. YAWN!!! This is a cute little rule, but the two biggest keys to determining asset allocation are:

  • Age – The younger you are, the more aggressive you can be. More than likely, a young person won’t need their money any time soon. That means heavy on a stocks, hold the bonds. As you age, you may find yourself less aggressive. Leave those stocks to the kids, you say. Load up on the bonds!
  • Risk tolerance – I know plenty of 20 somethings who have sizeable bond holdings. I also know 40 somethings who are heavy stock holders. Risk tolerance is not tied to your age. I will say that most folks overestimate their risk tolerance. You should really sit back and think about can you handle the market taking a 15% dip.

Asset allocation is represented by a set of numbers. First number is bonds and second number is bonds. In heavier diversified portfolios, it’s quite common to see a third and even fourth number. We are dealing in super simple world in this article, so only investing two ways. For example: 80/20% is 80% stocks and 20% bonds or a 70/30% is 70% stocks and 30% bonds and so on and so forth.

I know that’s a lot of digest so I’ll save you some more gray hair. Most employer sponsored 401(k)s offer something called “Target Date” funds. These are curated portfolios that take all the guesswork out of trying to construct a portfolio. Check out your plan’s fund list. I’m pretty sure you’ll see something like “Target Fund 20xx”. If you delve deeper into each of these funds, you should see the target asset allocation for the fund. Typically the earlier the date, the more conservative the fund. E.g. Target Fund 2025 will be less aggressive than Target Fund 2045. I will say that I am a huge fan of passive investing and I find target funds to be the move for most investors.

One super important thing to mention about 401(k)s. You may have heard the word “vested” thrown around. Vested means ownership. You can be partially vested or fully vested. Partial vesting means if you leave the company before the allotted vesting period, you only will only get part of your money. For example: GinormaCorp fully vests an employee after 5 years. Their vesting schedule is 20% each year. Employee gets fed up and leaves at 3 years. Employee can move all of their contributions and earnings plus 60% of employer contributions and earnings. Now if Employee lasts 7 years, every single penny in their 401(k) is theirs. They are fully vested!

This 401(k) thing is sounding pretty sweet? It is. However, 401(k)s can go left really quickly if you try to tap into them before hitting 59.5 years of age. First things first, by all means do NOT withdraw funds early. You will be taxed to no end and will have to pay penalties to boot. At last check, it’s a 10% early withdrawal penalty PLUS income tax. Also, it hurts your future because the money you took out won’t be earning that sweet compounding interest.

Some plans allow for hardship distributions. In order to claim a hardship distribution, you must have an immediate and heavy financial need. In addition, the hardship distribution is limited to the amount necessary to handle said immediate and heavy financial need. I implore you to find other sources to handle needs like this.

Another way folks get tripped up is by taking out a loan against their 401(k). I differ from most of the financial bloggers because I think there are some legit reasons to borrow. Now just because they are legit doesn’t mean you should take out a loan. My top reasons to take a loan against a 401(k) are home buying or further education. Dassit. And not just any old house and not just any old degree. These better be sure shots.

The main thing to consider when thinking of taking out a 401(k) loan is how stable is your job? If you resigned, are fired, or laid off the full balance of the loan comes due within 60 days. Don’t have the money by then? Oh that’s cool, if you don’t mind the balance becoming an early distribution. Yep that means income tax and that 10% penalty. Oof!

401(k)s are a great way to save for retirement. They are super simple and are very powerful. Even if you invest in the most boring vanilla bond funds, you are working towards a better retirement. Know your time horizon and know your risk tolerance. Invest. Chill. Let it work for you.

What say you? Are 401(k)s all they are cracked up to be? Hit the comment box and let’s talk about it.

 

 

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