An Overview of the 401(k)

The 401(k) takes it’s name from section 401(k) of the Internal Revenue Code. A 401(k) plan can give employees a tax break on money they contribute (depending on if it is pre or post tax). In 2021 the annual contribution limit is $19,500 (and $26,000 for those age 50 or older).

Every year, in the fall, the IRS will review and (sometimes) adjust the maximum contribution limits for the 401(k), IRA (individual retirement account), and other retirement vehicles.

The unfortunate truth is some companies provide better 401(k) plans than others. Ideally, you want your plan to have low fee funds and low management expenses. However, sometimes, this might not always be the case, and if you cannot avoid high fees, you may want to consider alternative accounts. It is wise for companies to avoid intentionally high fees, lest they get sued by their employees.

But, let’s assume that you have a fantastic 401(k) option at your work. What are some things to do.

Deciding how much to contribute

Most companies will offer a matching contribution. This generally means that a company will “match” your contribution dollar per dollar based on your total compensation. Sometimes these match dollars are instantly vested, sometimes they vest over a period of years.

An example of this might be “100% matching the first 3%, 50% matching the next 2%”. This generally means you will need to contribute 5% of your total salary to get the full 4% match. And this means you get to do math to determine how much you will need to contribute. Some companies let you contribute a percentage of your paycheck, and some let you specify a dollar amount.

In general, it’s “free money” to contribute enough to get the full match. However, this amount might not be enough to plan for a “full retirement”. Another way to think of the match is that it’s the equivalent of earning a guaranteed 5% return (using our example). It’s basically ignoring part of your total compensation.

On the other side of the spectrum, you could contribute the maximum amount allowed. This means needing to look up the maximum contribution every year and adjusting it every year. In 2021 the max for workers under 50 is $19,500. Those 50 and over are allowed to make additional “catch up” contributions, so they have a max of $26,000.

If setting aside that much money gives you a slight panic attack (or makes you laugh), you should pick something in between getting your full match and “maxing it out”.

Tax Benefits of the 401(k)

There are two different types of 401(k)s: a traditional 401(k) and a Roth 401(k). Both accounts allow tax-free growth. Meaning you can buy and sell without worry about capital gains taxes. This allows significantly easier rebalancing than in a taxable account.

Traditional 401(k)’s you can defer taxes on the amount you contribute. For example, if you earn $90,000 a year and contribute the (2021) max of $19,500, your taxable earnings (before other deductions) will be $70,500. You will instead pay taxes when you take money out of your 401(k) in the future.

If you instead contributed to a Roth 401(k), in this same situation, your taxable earnings (before other deductions) would remain at $90,000. However, all contributions and earnings will come out tax free when you take money out of your 401(k) in the future.

If you have access to both the 401(k) and the Roth 401(k) you can mix and match your contributions, but they have a combined contribution limit of $19,500. It’s also worth noting, if you switch employers a lot and use a Roth 401(k), you will save yourself a lot of heartache by noting the first year you contributed to the Roth 401(k) and the cost basis (how much you put in that first year).

So, which is better? It honestly depends on a comparison of current vs future tax rates. In general the “rule of thumb” is: If your marginal tax rate now is higher than your marginal tax rate will be later (when withdrawing, not while contributing), then the traditional is better. If it is lower, then the Roth will be better. If it is the same, then pick your favorite :-D.

It is worth noting that working state and intended retirement state can be factored into which you may choose to pick. Some state are very friendly to retirees because of low income tax.

Much ado about fees

Almost all 401(k) accounts also come with fees. It could be tacked onto a fund itself, or a set fee charged every quarter/year for the account itself.

You should consider fees when picking your mutual funds. Please note that most actively managed funds have significantly higher fees than passive index funds. The higher fees of the active fund can sometimes wash out the performance they may or may not produce over time. Not to mention high fees will eat at your return by creating a higher drag.

But what to do if you can’t avoid it?

There are a few options: One is to not roll any other existing 401(k) accounts into your new one. Another thing to realize is it’s fairly rare to stay at a company an entire career these days. If you leave your job, take your money with you.

Another thing you can do is to petition your company to change 401(k) providers, or add additional funds that include a low cost option.

Asset Allocation

Your asset allocation, or your investment strategy that includes your risk tolerance, investment timeframe, and asset classes, is an important decision to make.

There is no simple formula to determine one’s individual asset allocation. Some people chose to be aggressive right up until they retire, some people pick an age-based asset allocation. Only you know your own risk tolerance and how you want to split it up.

The age-based asset allocation is fairly simple. The rule of thumb is 100 – your age to determine the percent of bonds you should have in your portfolio.

A common thing more and more providers are offering these days are “target retirement” funds. These funds will change the asset allocation automatically as time gets closer to a year most closely matching the “target retirement” (these tend to be every 10 or 5 years). Another plus is these funds have a low expense ratio, so there’s nothing much to do.

If you wish to go it your own, you can pick between any funds your plan might offer.

Lawsuit protection

The federal government has special protections for employer-sponsored 401(k)s. These are protected by the Employee Retirement Income Security Act. However, it is state dependent for other types of retirement accounts (such as IRAs) and lawsuit protected.

Conclusion

You should think about the future and how to afford retirement. The 401(k) is one of many types of funds you can set up for a great retirement.