What is a 401k: How to turn savings into retirement security

For some of you retirement can seem far away. But, saving money early is crucial for having a comfortable amount once you stop working. Ideally you start saving for retirement once you get a full time job. This will allow you to take advantage of a variety of retirement accounts. The two main benefits of retirement accounts are the tax advantages and the power of compound interest over a long time. Taking advantage of tax benefits and compound interest can add up to an extraordinary amount of money in the long run. To reap these benefits to the fullest extent, it’s important to invest in retirement accounts early, like a 401k. So what is a 401k? I’m here to help in understanding the different popular retirement accounts.

401k

401k is the most popular retirement savings account offered by employers. You contribute a part of your gross salary, on a pre-tax basis, to a 401k. This means you can invest pre-tax money from your paycheck into stocks and bonds. You won’t have to pay taxes until you pull out your earnings when you retire (at least age 59.5 years old as of 2024).

Usually the company you work for will work with a 401k provider (ex. Fidelity, Vanguard, etc.) on pulling money from your gross paycheck into a 401k plan. In this plan, you can decide to invest in index funds or a managed mutual fund. You can also select a “target retirement date”. For example, the “Vanguard Target Retirement 2050 fund” is a mutual fund that will adjust stocks/bonds allocation to assure the least amount of investment risk in the year 2050. 

Here are three main benefits of 401k plans:

• Tax-deferred gains: You don’t have to pay taxes on anything invested in your 401k plan until you withdraw funds
• Employer-match: Your employer will match what you put into your 401k to a certain point. A typical employer match is up to 50% of 4% of your income. If you put 8% of your gross income into a 401k plan, your employer will give you an extra 4% of your gross income as well! This would be a total of 12% of your gross income invested into your 401k every year. Check with your employer if you have this benefit
• Tax shelter on present income: By contributing to your 401k, you can bump yourself to a lower tax bracket now

Here are three drawbacks of 401k plans:

• High taxes: Taxes increase over time. When you retire and withdraw funds from your 401k, it will likely get taxed at a higher tax bracket
• Withdrawal penalty: Withdrawing money before age 59.5 will lead to 10% fee plus taxes. Only put money in your 401k you are sure you wont need to withdraw this money before the age of 59.5!
• Contribution limit: can contribute at most $23,000 a year (as of 2024)

The main benefit of a 401k is that it’s a tax shelter for present income. This means it is a way to reduce taxable income now, so that you can make investment gains with pre-tax dollars. The main drawback here is that when you retire, your tax bracket will likely be higher than it is now. For example, if you pay 25% taxes now, you could be deferring your taxes to a time where your taxes may be 37% of your income. To combat this drawback, a lot of people invest in something called a Roth 401k. 

Roth 401(k)

A Roth 401k differs from a traditional 401(k )in one major way. With a Roth 401(k,) contributions are made with after-tax dollars. This means money gets pulled into your Roth 401(k) from your NET paycheck, rather than GROSS paycheck. The main advantage here is that this post-taxed money can grow as an investment. Once you retire you can pull this money out without paying any taxes! If you invested this money in the S&P 500 index fund over the past 40 years, the average rate of return would have been about 11% a year. Cumulatively, this 11% translates to roughly 6,500% return on your money. The best part is this wouldn’t get taxed upon withdrawal! 

Here are two main benefits of Roth 401(k) plans:

• Tax shelter on future income: Tax-free growth/withdrawals
• Predictable tax rate: Taxes increase over time. Pay taxes now at a rate you know, rather than a high tax rate years down the line when you retire 

Here are two drawbacks of Roth 401(k) plans:

• Contribution limit: $23,000 = sum of contributions from Roth 401k and traditional 401k
• Not a tax shelter on present income: As you progress in your career, your tax bracket will likely increase. Contributing to your Roth 401k rather than a traditional 401k will mean paying these high taxes now. 

The main benefit of a Roth 401(k )is that it’s a tax shelter for future income. The main drawback is that it is not a tax shelter for present income. If you are in a high tax bracket, contributing to Roth 401k does not give you present tax benefits like a traditional 401(k )would.

Another drawback here is that if your employer gives you the option of a traditional 401(k) and a Roth 401(k), the max contribution limit of $23,000 gets shared among both accounts. You can split contributions to both of them and get the best of both worlds. The problem with that is that you are also getting the worst of both worlds, getting the drawbacks of both! I suggest an adaptive approach:

When you are young and in a low tax bracket, take advantage of Roth 401(k). Max this account out to the gills. The reason is that you are being taxed the lowest you will ever get taxed in your life! Take advantage of gaining (tax-free) compound interest for a long time by starting young.  

Summary

As you age and advance in your career, your tax bracket and income will increase. At this point, I recommend having a tax shelter now by investing in traditional 401k instead of Roth 401(k). This will lower your taxable income in the present and put you in a lower tax bracket. For more tailored advice for your specific financial circumstances, I recommend discussing with a profession at a company like empower or Fidelity.

Now you might be asking, where would your original Roth 401(k )money go in this case? Move your Roth 401(k )contribution to another Roth account. A popular one is a Roth IRA, and we will leave that discussion for another day!

There are a lot of nuances about Roth 401(k )and traditional 401k that I haven’t covered. Some questions might be about how much to contribute, what to invest in for either accounts, and more. This is also a discussion for another blog, where you can learn about asset allocation and index funds. For now, please take this blog as an intro to what you can start to think of for retirement (compound interest and tax shelters). It’s important to start early to get the highest utility out of these financial benefits!