May 11th, 2020

Welcome to Pt. 3 of the Pre-Tax Accounts Series! Let’s cover 401k’s!

What is a 401k?

A 401k plan is a tax-advantaged defined-contribution retirement account. Employees can make contributions to their 401k accounts through automatic payroll and their employers can match some, or all of their contributions.

Types of 401k’s

There are many types of 401k’s including: traditional, roth, safe harbor, simple, solo. In this article I’ll cover traditional 401k’s because it’s the most popular of the bunch and what I currently have. Let me know in the comments if you would like me to cover the other 401k accounts.

How does a 401k work?

First, you need to see if your employer offers a 401k as part of your employment benefits. If they do, then you elect the percentage of how much of your paycheck you want to contribute towards your 401k account. For traditional 401k’s, the payroll deduction is pre-taxed and you pay taxes once you are distributed the funds.(There are exceptions, keep reading.) Generally, you can change the percentage at any time. I’ll explain how this was helpful for me later on.

Since your 401k contributions are deducted pre-taxed, your taxable income is lowered, which reduces your tax bill. If you made $50,000 a year and you contributed $10,000 to your 401k, you will be taxed as if you made only $40,000! Come on tax savings!

Contribution Limits & Age Requirements

For 2020, the annual employee contribution limit is $19,500, for people under 50 years old. Employees over 50 years old, can save an additional $6,500, for a total of $26,000. This is called a catch-up contribution.

Your employer may match some, or all of your 401k contributions. You should be informed about how much your employer will match for your 401k contributions, so consult your Benefits or HR Dept. More on my company match is discussed below. For employee and employer contributions combined, the annual contribution limit is $57,000.

There are some exceptions, but generally, you can be distributed 401k funds penalty free, once you are 59 1/2 years old. If you retire or lose your job after you turn 55, you may be able to receive 401k funds penalty free. This only applies to the 401k contributions made to the employer you just left. Contact your employers Benefits Center or HR Dept. for more information.

How much should you contribute to your 401k

I know people like to hear a solid answer to this, but there isn’t one. You’ll see a lot of general answers online. I have heard and read: 10%, 20%, 10%-15%, max-it-out, and more. It honestly depends on your current financial health(more on this in future articles) and your life goals. If you’re able to, at least match what your employer will match. So if your employer will match up to 4%, contribute at least 4%. Contributing the amount that your employer will match is literally free money. More on my personal thoughts about 401k contributions later in this article.

What is your 401k invested in?

First let’s cover asset allocation. Asset allocation is implementing an investment strategy that attempts to balance risk vs. reward by tailoring the percentage of each asset in an investment portfolio according to the investor's risk tolerance, goals and investment time frame. Generally, the asset allocation for your 401k contributions are spread in between stocks, bonds, and money market investments. Most likely, the spread will already be determined for you and you are able to modify this spread as well. It is best to do your research to educate yourself, or hire a professional to determine the best asset allocation for you.

Vested vs. Non-vested

When you are vested in your 401k, you OWN your contributions and your employers contributions. In the event you leave your employer, you can take your contributions and your employers contributions with you. While you are non-vested, you only OWN your contributions. So if you were to leave your employer, you can only take your contributions, while your employers contributions are forfeited.

Many employers have a service requirement, in order for you to be vested in your 401k. For example, you may have to work for your employer for 3 years, until you are vested in your 401k. It is important to know this information. Contact your employers Benefits Center or HR Dept.

When should you start investing in a 401k?

ASAP, period. But ASAP especially, if your employer will match your contributions. Also, ASAP especially, if you have dependents, or plan to have dependents, because they can inherit your 401k funds once you pass. More on this topic in future articles. Also, it’s never too late to start! Whether you’re 19, 29, 45, or 50+, it’s never too late!

How to receive funds from 401k

Retirement

Once you retire, starting at age 59 1/2, you may start to receive your 401k distributions without a penalty. You may choose to take regular distributions in the form of an annuity(more on this in future articles), either for a fixed period, or over your anticipated lifetime, or to take non-periodic or lump-sum withdrawals. You may be far from 59 1/2 now, however, if you plan on solely using your 401k for retirement, you need to know this information NOW. Contact your employers Benefits Center or HR dept.

Withdrawal

When you withdraw from your 401k, generally, you will be charged a 10% penalty, plus taxes. You have to report the 401k withdrawal as income. However, you may not be charged the 10% penalty depending on your employers plan and the reason for withdrawal. Expenses like medical emergencies and funerals, may be considered a hardship distribution and be penalty-free. Generally, you need to provide proof of the financial hardship for the penalty to be waived. As I said throughout this entire article, ask your employer for the specifics of your plan. You have the right to know.

Loans

A 401k loan is a loan that you can take using funds from your 401k. There is NO PENALTY and NO TAXES on 401k loans. However, you do have to pay interest on the loan. But guess what? That interest goes to you. Yes, you understood it correctly. With a 401k loan, you are loaning yourself money and paying yourself interest for the duration for the loan. You can use a 401k loan for whatever you want and don’t have to prove the reason for using your 401k dollars, like you have to with a withdrawal. You do have to pay back the loan using post-taxed dollars.

The interest rate on a 401k loan depends on your employer. Generally, the 401k loan interest rates are less than the interest rates of credit cards and personal loans, making it a viable option for many people. Generally, you are able to take out a loan of either half of your 401k balance, or up to $50,000 and your employer will make automatic payroll deductions to pay back the loan.

Also, 401k loans are NOT considered income, so no need to be concerned tax time! More on 401k loans and withdrawals in future articles.

Penalties

The IRS will charge you a 10% penalty of the amount you withdraw, plus federal income taxes. Depending on the amount you withdraw, the total numbers of fees can be HEFTY! This is something to think about when determining whether or not to withdraw from your 401k early. However, in these trying times, the 10% penalty may be waived👀, see below…

401k & the CARES Act

“In general, section 2202 of the CARES Act provides for expanded distribution options and favorable tax treatment for up to $100,000 of coronavirus-related distributions from eligible retirement plans (certain employer retirement plans, such as section 401(k) and 403(b) plans, and IRAs) to qualified individuals, as well as special rollover rules with respect to such distributions. It also increases the limit on the amount a qualified individual may borrow from an eligible retirement plan (not including an IRA) and permits a plan sponsor to provide qualified individuals up to an additional year to repay their plan loans. See the FAQs below for more details. “ - IRS

Click this link for the details!

SSS Personal experience on 401k’s and Final Thoughts

• I have been contributing to my 401k since I was an intern for the company I currently work for. So, about 8 years.

• My employer matches 6% of my 401k contributions, plus an extra 2%. I have matched my employer for every year of my employment except in 2018. I became pregnant and wanted to put all the money I could into my HSA. By doing this, I had enough money in my HSA to cover all hospital, lab and doctor bills for the birth of my daughter. No🙅🏾‍♀️ post-tax dollars were used!

• I plan on having many streams of income for retirement, so how much I contribute to my 401k is tailored to my plan. It is smart to develop a retirement plan, no matter how old you are and this plan can always change!

• I prefer 401k loans, rather than withdrawals. The 10% penalty, on top of the federal income tax, is not a favorable option for me. I rather pay interest to myself and have automatic payroll deductions, so I don’t have to worry about paying the bill every month.

• It took me 3 years to be vested in my 401k, and 5 years for my pension. More on pensions later.

• I like the fact that my daughter can inherit my 401k, if I do not use all the funds. Generational wealth!

Final thoughts… My 401k continues to be a valuable asset in my investment portfolio. My favorite perk is that I can have access to the funds before 59 1/2 in the form of a loan, which will end up making me more money long term.

Do you have a 401k? If so, do you max it out? Do you have a certain amount that you want to have saved by retirement? Was this information helpful? Did you learn anything new? Let me know in the comments below or on Instagram or Facebook!

**Check with your employer for rules and limits on your 401k plan.**