I’ve been getting quite a few questions about 401(k)s lately; mainly people asking if they should contribute to their 401(k) or how much to contribute. So, I figured I’d write a brief 401(k) post.
401(k)s hold a special place in my heart because growing up I distinctly remember people talking about them, but I had absolutely no clue what they were. In my mind, they were a complex insurance or money thing that adults had to deal with. Even as I got older and began to work and start college I would occasionally hear people mention them, but I was either too afraid or just didn’t care enough to inquire about them.
It wasn’t until I was in the middle of my personal financial planning courses in college that I finally learned what a 401(k) was. After I heard a simple explanation, I remember feeling empowered. This scary adult thing, like investing, wasn’t some mysterious process anymore.
So, for the people reading this who may be like me, let’s start with a simple explanation of what a 401(k) is.
A 401(k) is an investment account, typically offered by companies to their employees, that has special tax benefits. A traditional 401(k) is a pre-tax retirement account, meaning that your taxable income is reduced by the amount contributed to the account. In other words, you don’t pay taxes on the amount you contribute. The money in the account is invested, it grows tax-free, and then income taxes are due when you take out the money in retirement.
In exchange for this tax benefit, there are rules for the account. You’re only allowed to contribute a certain amount each year (up to $19,500 for 2021, not including an employer match) and you can’t take your money out of the account before you reach age 59 1/2 without incurring a 10% penalty.
The reason you’d want to avoid taxes now and pay them later is that the overwhelming majority of people will be in a higher income tax bracket when they’re working compared to when they’re retired. Around 80% of people have an effective tax rate of 0% in retirement.
Putting money into a 401(k) is a great way to lower your tax burden while also investing for your future. Naturally, the next question that begs to be asked is how much should you be contributing each year?
Most personal finance experts will tell you to put as much money into your 401(k) as possible. This seems like logical advice and definitely isn’t a bad thing to do with your money, but is it really the best thing to do for everyone all the time?
First off, you should always take full advantage of your employer match. This is something I don’t consider up for debate. An employer match is a benefit in which your employer will match any contributions you make to your 401(k) up to a certain percentage. For example, if you contribute 5% of your salary, then your employer will also contribute an additional 5% to your account.
This is free money and part of your compensation from your employer. If you don’t think you have enough room in your budget to take advantage of it, then you need to make room.
Contributing beyond the employer match is when you have to start considering the tradeoffs of the account. Yes, a 401(k) provides a tax benefit, but the tradeoff for getting that tax break is your money is “locked up” until you’re 59 1/2. The penalty associated with taking your money out early will typically negate or exceed any tax benefit you received.
So, any money that you put into a 401(k) should be money that you won’t need to use until you retire.
Because life is unpredictable and you never know when you may need the money you’ve stashed away, I think it’s prudent to balance your savings between a 401(k) and a regular investment account that you can access without penalty for things like a house down payment, a career change, or whatever else life decides to throw at you.
Flexibility should be an important factor when deciding where to invest your money, especially when you’re young.
Nick Magguilli wrote an article where he looked into the long-term tax benefits of investing in a 401(k) versus a regular investment account. He found that after you factor in common fees associated with 401(k)s, a typical 401(k) plan provides somewhere between 0.38% to 0.73% in extra return each year due to tax-deferred growth.
He then asks, is 0.5% to 0.7% extra return a year worth locking up a significant portion of your wealth until you’re retired?
On the flip side of this argument, the inflexibility of a 401(k) does have some behavioral advantages that help a lot of people. The funds are automatically taken from your paycheck and invested regularly while the barrier to accessing the money forces you to keep the money invested which leads to superior investment performance over time.
In the end, how much you should contribute to your 401(k) depends on your personal circumstances and goals.
There are no universally right answers that make sense for everyone. Just different shades of gray that work for people’s unique situations and personalities. Making smart financial decisions is all about managing trade-offs.
Thanks for reading!