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Investing at Work – Understanding your 401(k) Options

401(k) Introduction:

The most frequent questions coming from young professionals are in regards to their 401(k) retirement savings accounts at work. Most major employers are transitioning their retirement benefits from the traditional defined benefit programs (like a pension plan where workers get a specified dollar benefit paid monthly in retirement) to a defined contribution plan like a 401(k) plan where employers agree to give you a defined amount of money now and let you invest it. This is a much less risky format for companies since they pass the investment risk to the employees and they don’t have to agree to pay someone for the rest of their life (whose longevity is undetermined and thus risky). But savvy investors will likely be able to receive much better returns in the long-term through investing the money themselves instead of having the company invest for them and then pay out a pension.

401(k) plans are offered by most large private sector employers. Similar offerings by non-profit and public education organizations include “403(b)” plans, and “457” plans for government employees. Since all three of these are very similar we will lump them together and refer to them collectively going forward as your “401(k)” plan (since it is the most frequently used). If your employer doesn’t offer a retirement savings plan then fast-forward to the next section to learn how to open an IRA (individual retirement account) to begin saving for your retirement.

The term 401(k) itself means nothing – it is just referring to an IRS tax code created in 1980 that allows for special tax treatment for these types of retirement savings plans. Every person who has access to these types of plans should absolutely take advantage of them. Most companies offer to match some portion of your contributions to your accounts, and those who delay setting up their contributions are essentially refusing to take free money. Get focused and set up your 401(k) account the first week you start your job.

These retirement savings plans are critical vehicles for young professional investors to use to save and invest for retirement. Saving for retirement, even though it may be 40 years away, allows investors to begin compounding their investment. Refer to the charts and descriptions in the “Stocks over the long run” section under the “Why equity investing” page to see how returns over extremely long periods build upon themselves exponentially to create a huge nest egg for you to live off of in retirement. In 2020 401(k) accounts allow for up to $19,500 in annual employee contributions so you have the ability to put a large chunk of funds away for retirement each year into these tax-advantaged accounts.

Monies contributed to these accounts are strictly for your retirement savings – the majority of withdraws before you turn 59.5 years old are subject to your regular income tax levels plus a 10% penalty (unless you face rare extreme hardships like a permanent disability) which is critical to avoid (referring to the penalty … but also please avoid permanent disabilities if you can). Therefore, we are going to set up a nice retirement savings account here and in the next section, we will take you through how to use your additional savings to begin investing for your personal account (which you can withdraw from at any time for emergencies or major purchases).

Generally, most employers offer only one type of 401(k), but a recent rule change has allowed for another 401(k) account type. You will need to decide which one is the best fit for you. Here’s a breakdown of your two options:

1) Traditional 401(k):

This is the most frequently used 401(k) account type. This account allows you to automatically send money into the account from your paycheck at a set percentage or dollar amount every pay period (which nicely follows one of our investing principles “make it automatic”). Whatever money goes into this account is not subject to income tax withdraws in your pay cycle, and you will not pay income tax on this money when you file your annual tax return. These are “pre-tax” contributions.

For example, you currently make $50,000 a year. You set a 5% allocation to your 401(k) and you get a match up to 5% of your contributions from your employer. So over the course of every paycheck that year you have contributed a total $2,500 to your account, and your employer also chipped in $2,500 … so you have $5,000 in your account. At the end of the year, you will only have to pay income taxes on $47,500 since you sent $2,500 of it to your retirement plan “pre-tax”. If your overall income levels put you in the 22% marginal tax bracket you will have avoided paying 22% in taxes on $2,500 (keeping $550 in your retirement savings instead of giving it to Uncle Sam).

But, you won’t avoid paying taxes forever. When you begin withdrawing money from this account in retirement in 30-40 years you will have to pay income taxes on all funds distributed at that time. What will the tax rate be then? Who knows! It will depend on your tax bracket in 30-40 years and what the marginal income rates are within each bracket at that point. Note that you will pay your marginal income tax rate on all of the money you take out, which includes the sizable gains that have built up over the decades (you will not pay the favorable capital gains rate which is currently 15%).

This point is at least 30, maybe upwards of 40 years away for many of us. Since our timelines for this money is extremely long, if you have the risk tolerance for it, 100% of this money could be allocated to stocks and none of it is left to lower performing long-term assets like cash and bonds. Please refer to the material on “Why Equity Investing” if you want to understand more about the risk and reward associated with a high equities allocation.

2) Roth 401(k):

The difference with this 401(k) account type is that you contribute money to the account “after-tax”, so you pay income taxes on everything and then send a percentage of your after-tax income to the account. “Roth” is the name of Senator William Roth of Delaware who sponsored the legislation to create this type of account in the late 1990s.

So in our previous example remodeled: You make $50,000 and are in the 22% marginal federal tax bracket. You elect to send 5% of your salary which after 22% in taxes paid is $1,950 to your Roth 401(k). Your employer’s match can’t be made after-tax due to silly tax rules so it is made as a 5% pre-tax contribution to a separate account, so only your contributions will receive the after-tax treatment. So, your employer kicks in 5% pre-tax of $2,500, and your ending year balance is $4,450 (spread across a pre-tax and an after-tax account).

So this is less than the $5,000 in the Traditional example, so it’s obviously a crappy deal right? Not exactly. All of the money you contributed to your after-tax account is now free and clear of all taxes forever. So all of the sizable gains that you will build up in the portfolio of your contributions over many decades are all yours. No kickbacks to the man required in 30-40 years. The money from your employer match, however, acts like a Traditional 401(k) where any withdraws in retirement from that account will be taxed at your marginal income tax rate.

Which account type is right for you? Essentially if you choose a Roth 401(k) you are betting that you will have a higher income and thus be in a higher income tax bracket when you distribute fund from the account after age 60 (even if you are retired … say through income off a business you own or sizable income from your non-retirement investments) compared to your income levels now, and/or that income tax rates within each bracket will be higher when you retire. This is ideal for a person currently in an entry level job that will be pursuing graduate degrees. The assumption is that you will make much more money later in life compared to where you are now, so you want to pay taxes now instead of paying them later.

For users of a Traditional 401(k) you are betting that you will have lower income levels in retirement (thus you will be in a lower income tax bracket then) and you wish to defer paying income taxes until this point. This would be best for persons in a career path that have high salaries now but limited income growth potential. You are also betting that the percentage rates within each bracket will be lower in the future.

Still can’t decide? The good thing is that as long as you are contributing to either type of account then you are on the right path. As we age we will finally have enough loots to where it makes sense to get a professional to help with this. It may also be strategic to diversify your tax bases…or in other words to have both types of accounts. That way you don’t have to imagine what the tax brackets will look like in 30-40 years since who knows, maybe the feds will shift to a sales tax strategy and radically lower income tax brackets? Or maybe you will stumble upon a lot of money later in your career and your original plan of paying taxes later in your life would then look unattractive!

Generally, young professionals are best off that if they are in a 22% marginal tax bracket then to use the Traditional 401(k) option (and then perhaps you can also fund a Roth IRA as explained in our following sections so you have money in both tax “buckets”). If you are within a 12% marginal tax bracket then a Roth 401(k) contribution could be attractive. As long as you start contributing now and you contribute enough to get the full match by your employer (if you have a 5% match available but only contribute 4% then you are avoiding free money) then you will be fine either way.

Selecting Funds Within Your 401(k) Plan:

Now you’ve got an account type figured out and picked a percentage of money that will flow into the account each pay period. So, where does that money go? Here we will go through the funds available in your 401(k) plan. Each employer selects various types of professionally managed mutual funds so this menu will vary from employer to employer. You aren’t able to select individual stocks or bonds, but rather you can choose from a limited number of mutual funds – or funds that will spread your money across many different individual investments. The chart below will try to give a generic description to match the fund that is likely available to you, describe what it is, and provide comments as to what general allocations to these funds would be ideal to an investor with a very long time horizon to retirement (20-30+ years). Remember your fund names and types will likely sound different but they should resemble the fund description provided below.

At the highest level – remember this money is strictly for investing for our retirement. This point is at least 30, maybe upwards of 40 years away for many of us. Since our timelines for this money is extremely long, it is best that 100% of this money is allocated to stocks and none of it is left to lower performing long-term assets like cash and bonds. Please refer to the material under the page “Why Equity Investing” if you still don’t agree or need more clarification on the importance of this item.

Please do your own research on funds in your plan before selecting your investments so that you understand the investment’s risks and expenses.