What is a 401(k)? | brokeGIRLrich
A 401(k) is a retirement savings plan that is usually offered by an employer.
If you work in education, your employer may offer you a 403(b), which is essentially the same thing.
Additionally, if you’re self-employed, you can open a SEP 401(k), though they are a bit more complicated and while the essence of a what a 401(k) is still remains, since you’re acting as both employee and employer for a SEP, it’s a whole different ballgame of rules.
401(k)s come in two types Tradition and Roth. You may or may not have the option to choose which you’d prefer, depending on your employer. 401(k) plans vary from company to company.
Traditional means you get the tax benefits now. You can deduct whatever you contribute from your income before paying your taxes. This means if you made $60,000 this year and contributed $10,000 to your 401(k), you only have to pay taxes on $50,000 of income.
Roth means you get the tax benefits later, when you withdraw the money. With a Roth account, you don’t get to deduct your contributions from your current taxes; however, that money and the interest the account gains, can be withdrawn tax free in retirement.
Generally, people decide whether they want to select a Traditional or Roth based on when they expect to be in a higher tax bracket – now or in retirement? So if you are in a high tax bracket now, it can help to take the tax break right now and then pay the taxes later in retirement, when you’re in a lower bracket.
If you’re in a low tax bracket now and expect it to be higher in retirement, it can help to select a Roth and pay the taxes now.
Since none of us have a crystal ball, this can be a little tricky to be sure of. And honestly, if you get it wrong, having a 401(k) of either type is much better than not having one.
Personally, since my crystal ball is always a little foggy, if I have access to a Roth option for retirement savings, I just pay the taxes now. That being said, in the three jobs I’ve had that offered 401(k)s and the one 403(b), Roth wasn’t even an option, so they were all Traditional.
401(k)s have contribution limits that usually go up a tiny bit each year (but not every year). For 2021, the contribution limit is $19,500. It’s ok if that number seems laughably high to you – you can contribute any amount up to that much.
If you are able to max out your account though, a benefit of 401(k)s can be the higher amount. IRAs have a much lower limit.
You may heard the phrase “always get the match” if you’ve been doing some personal finance research.
A lot of 401(k)s offer a match up to a certain percentage of your salary each year. So say one of your job perks is a 4% match.
If you contribute 4% of your salary to your 401(k), your employer will then match your contribution. It’s kind of like free money, because even though everyone in your job company has this perk, your employer is well aware that lots of people won’t use it.
You also need to keep an eye on a phrase called “vesting.” Vesting is often a timeframe selected by an employer and if you leave the company before that time frame is up, you can lose all or part of their contribution to your account (your part of the contributions is always yours).
So for instance, if a company says you are vested at 0% until 3 years of employment, that means that if you leave within 3 years, you loose what they have contributed to your 401(k).
If a company says you are vested at 33% each year until year 3 when you are fully vested, that means If you leave after 1 year, you get to keep 33% of the money they contribution. If you leave after year 2, you get to keep 66% and if you leave after year 3, you get to keep 100% that they have contributed.
After opening your account, your next step is to pick what you want to invest in. Your HR department can usually provide you with a list of funds available, because most 401(k)s only give you access to certain funds to choose from.
Sometimes this is nice because it can be overwhelming to decide what to invest in.
Sometimes this is unfortunate because the funds are all garbage. If this is the case, pick the least garbage-y to get to your employer match and then consider putting the rest of your retirement savings in an IRA, HSA or even a brokerage account for better returns.
If that feels overwhelming though, a less than stellar fund can still be better than no retirement savings
But how do you pick between the funds?
My personal recommendation would be to find a family member or friend who understands personal finance and ask them to look it over with you.
You can also ask your HR department if there’s anyone there that can explain them to you or if the company has any connections to financial planners that you could speak with. Even if they don’t, it could be worth the fee to speak with a CFP (certified financial planner) to have them review the funds with you – especially if you plan to work for the company for a long time.
If none of that is an option, see if there’s a target date fund (this fund will have a vague name like Fidelity 2065) or a general index fund option. Both of those are probably ok choices – again, they are better than getting stuck in analysis paralysis and doing nothing.
From there, it should be pretty set it and forget it. The contributions should come out of your paycheck before you even see it.
The next time you have to think about your 401(k) is when you leave a company.
I’ve had a couple of different experiences with my 401(k)s.
My first 401(k) was with a massive entertainment company and I left after 1 year, and was unsure if I planned to return or not. It had a vesting schedule and I was not fully vested (it took 3 years to be fully vested). I just left the account as is, in case I ever return.
My second 401(k) was at a theater I worked at for a year and could only contribute a little bit to. It did not have a match. I cashed it out (by accident) after quitting. I went on tour after that job and didn’t receive any of the letters asking me what I wanted to do with the 401(k), so when I got back after several months, there was a check waiting for me – that I had to pay taxes on.
To be fair, at that time I didn’t really know what to do with a 401(k), so I probably would’ve cashed it out anywhere. There was only about $1,000 in it.
My third 401(k) was quite large because I was able to max it out the two years I worked for the company. I also just let it sit there after I left that job because at the time I didn’t have anywhere to rollover.
A rollover is what it’s called when you move your 401(k) from one company to another. It’s actually just a few pieces of paperwork and not that difficult at all.
However, the company decided to end their 401(k) program after I left and notified me that I needed to figure out what to do with this 401(k). Fortunately, I had opened a SEP 401(k) and was able to rollover the balance into the SEP plan. Vesting was not an issue because this company also did not have a match.
Despite two of those companies having no match, I was still happy to use their 401(k)s because it allowed me some tax savings and made it easy for me to save without thinking about it, since the money went right into my 401(k) before I even saw it in my paycheck.
However, I will say that any year without a match, I also made sure I could max out my Roth IRA first. I also prioritize my HSA above a 401(k) without a match.
