401K explained in layman’s terms

401K
Is this your retirement plan?

401K and “The Match”

This post is on the topic of the 401k, explained in lay person’s terms. Big thanks to one of the smartest guys we know. It would not have been able to be written without the help of a financial guru we really admire and consider a personal friend, @barstonel. Seriously, you should follow this guy.

This post came up because of a couple of different reasons. @barstonel and I worked together at a Fortune 100 company and found that most recent graduates were not familiar with 401k’s. They had heard of the term, they knew it as a retirement plan, but they didn’t understand the mechanics and benefits. This makes complete sense. If our company is their first job out of school, they probably haven’t run into a 401k plan before. The schools are not providing education on the 401k and most of us don’t listen to our parents when they tell us to save money. Not fully understanding a 401k is understandable. I just can’t sit back and not do anything about it.

401K 101

This is an introduction to the 401k. I am not going to go into IRA’s or stock options. If you are going to participate in a 401k, because of compounding interest, the earlier you start the better. I want to give folks a foundation on the 401k so they can start their exploration for further information. My goal is to seed inspiration so we ask questions. I am OK with folks not participating (sort of) as long as it is an informed decision. I also want to show the benefits of the misunderstood “match”.

So who is Ringo and @barstonel?

@barstonel has a biochem degree, worked for biotech his entire career in finance departments and has his MBA. Yes, he is maxing out his 401k. Ringo is an HR guy. He is not a CPA, an investment broker and does not have his Series 7. I am just trying to provide information on a very basic and misunderstood benefit that most companies offer and yes, I am maxing out my 401k. When I have worked at companies that didn’t offer a 401k, I pitched the exec team and made sure we did.

What is a 401K?

A 401(k) is a retirement savings plan sponsored by an employer. It lets workers save and invest a piece of their paycheck before taxes are taken out.  Taxes aren’t paid until the money is withdrawn from the account.

Before we go into the mechanics of a 401K, let’s get some basic facts out there.

  • 401’s are voluntary. Employees do not have to participate and not required to contribute to the fund.
  • This fund is not the company. The company is not able to access these funds. These funds are the employees. The company pays a third party to manage the funds on behalf of the employee, but the company doesn’t have access to the funds. They can deposit funds on behalf of the employee but are not able to withdraw.
  • You can stop your contributions at any time and you can adjust your contributions at any time. If you are 25 years old, you are NOT locked into a 40-year commitment of contributions.
  • If you move from one job to another, you can leave your contributions in the original fund or you can move them to your new employer’s fund. No tax penalty.
  • We are living longer than we were. Recent graduates are expected to live to be 89 years old. If you retire at 65, we need to sack away enough savings to last us 24 years. If you are living off $50,000.00 a year now you will need at least $1.25M to retire at today’s costs. Remember, your cost of living will probably be more when you are in your 60’s.
  • The company offers a 401K as a benefit to its employees. Government regulations allow employees to save up to $18,000.00 tax-free through a 401K, or $24,000.00 for those over 50 years of age. Without this benefit, government regulations only allow savings up to $5,500.00 tax-free through an IRA, or $6,500.00 for those over 50 years of age. Some companies feel that it is their responsibility as an employer to provide a retirement plan for their employees. Other companies try to differentiate themselves as an employer by offering more robust benefits in their competition for talent.
  • The employee designates how much money they would like to be taken from their paycheck (pre-tax) each paycheck and these funds are invested and managed by a professional, third party. The employee has the choice on what funds they want to have their funds invested in. If the employee is unsure, the third party usually has a simplified formula ANY employee can use to figure out what funds they should invest in. This formula just asks a few questions.
  • Years until retirement?
  • How much do you feel you will need a year after retirement?
  • Is your personality type risky or conservative? (How much risk do you want to take with your funds)
  • Folks early in their career will usually weight their funds in more risky categories (with higher investment returns historically) and those later in their careers will shift to the conservative. The thought is not because of youth being reckless. The thought here is that if something happens to the economy and things go badly, a young person has more time to make up for any negative swings. A person later in their career won’t have as much time to make up losses so may want to play it a little more conservative.
  • If we do take the funds out, we pay a penalty. Some 401k’s will allow you to borrow against your funds.

The Match

This is what the 401K is all about.  How does the 401k trump most of the other benefits out there? This is where you NEED to pay attention. Some companies “match” the contributions that the employees make into the fund. Companies that match are usually larger and profitable, but in markets where employers compete for talent, small startups will offer a “match”.

Let’s say you make $50,000.00 a year. 4% of $50,000.00 is $2,000.00.  Spread out over a year’s time, this would be 24 contributions (paychecks are issued two times a month) of $83.33.

Over the course of a year, if an employee contributes $2,000.00 into their 401k, at the end of the year, the company will match that $2,000.00 and put that additional $2,000.00 into the fund in the employee’s name.

The employee’s $2,000.00 contribution just became $4,000.00.

So, your $50,000.00 salary just turned into $52,000.00. This is an extra 2-week paycheck!!

If you do NOT participate in your 401k

You can spend the money instead of contributing to your 401K, but remember, this $2,000.00 becomes $1,500.00 after Uncle Sam takes his 25% tax.

BUT:

Contribute $2,000.00 ($83.33 per paycheck) over the course of a year. If your company matches up to 4% on a $50,000.00 annual salary, they will be contributing an additional $2,000.00.  That $2,000.00 contribution just became $4,000.00 and we saved $500.00 in taxes.

You can think long-term, contribute $2000.00 and turn it into $4000.00. OR, you can think short term, plan to spend $2000.00 and only end up with $1500.00 after taxes. $4000.00 vs. $1500.00, you do the math.

Our personal counsel

If you do not have any other alternative forms of savings (EG: IRA, Stock portfolio, etc.), start a 401k. It is easy, convenient, and tax-free.

Per government regulations, we can contribute up to $18K a year, or $24K a year if over 50 years of age. Early in our career, we may not be able to afford the full $18K, but as we get more seniority and larger compensation packages (thanks to Career Tracker), we will be able to contribute more over time. So just contribute what you can. Maybe it is $25.00 per paycheck, maybe it is $50.00 per paycheck. Think about how much we spend on coffee, Coke or cigarettes every 2 weeks. I am not asking you to go cold turkey, but just look for perspective in your spending vs. saving. Your future self will thank you, me and @barstonel.

If we receive a raise or a cost of living adjustment, we can contribute some or all of the additional income into our 401k. We were able to live without the raise so we won’t miss it if it goes into savings. If we were living on $50k a year and received a raise to $52K a year, use part of or all the $2K increase for additional 401k contributions.

Seriously,  follow @barstonel.  You know that guy is maxing out his 401k contributions and skipping out on a new pair of shoes to do it.

Key Takeaway: If your company offers a match on their 401K, take part! It is part of your compensation package, so do not leave money on the table. If it is difficult to start contributing, you can start small and increase your contribution percentage over time. You will not regret it!

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