The 401(k) Plan. Per the IRS, a 401(k) Plan is used to allow employees to contribute a portion of their wages to individual accounts of a qualified profit-sharing plan. What does this even mean? Let’s take a deep dive into what a 401(k) plan is, its uses, and what it does for you!
401(k) Plan – The Beginning
The first 401(k) Plan was founded in 1980, 2 years after Congress passed the Revenue Act of 1978 which included Section 401(k). This plan would allow an employee to deposit pre-tax money into a defined contribution account and allow the employer to match the contribution.
In 1981, the IRS published a ruling allowing an employee to contribute to these plans with payroll deductions, making it a one-time decision by the employee to contribute to their retirement. No longer would an employee need to remember to make contributions into their retirement account. It would be automated for them! By 1983, nearly half of all large companies had developed their own 401k plans. There was no looking back!
Fall of the Pension Plan
Section 401(k) of the Internal Revenue Code allows for employees to avoid being taxed on deferred compensation. This code, along with subsequent rulings made by the IRS, has led to the rise of the 401(k) Plan and the fall of the traditional pension plan.
Why did this happen? Money, of course! A 401(k) plan, by itself, has minimal costs to the employer. Other than some basic fees, all of the risk is on the participants of the plan. If the funds go down in value, the employer doesn’t need to make up any of the balance to make sure the participants still have enough to retire. This is not how the Pension Plan operates, it’s in fact, the exact opposite.
With a traditional pension plan, all of the risk is on the employer, with minimal risks to the participant. Traditionally, the employer would contribute a set percentage of the employees pay to the pension plan. In more recent times, the employee also helps by contributing a percentage to the plan to help shoulder the load. These percentages could be over 20%! So rather than contributing an additional 20% on top of your salary to the pension plan, a company would gladly give you a 5% match on your 401(k) contributions. They are savings 15%! That’s huge!
Benefits of the Basic 401(K) Plan
So what are the benefits of the 401(k) Plan? First off, you contribute with pre-tax dollars. This essentially lets you lower your taxable income in the year in which you make the contributions. Of course, we all know the government will always get their money. You pay for this tax savings by paying taxes on you full withdrawals when you decide to take out your money.
An employer can decide to match contributions into the 401(k) plan. Many will match up to a set percentage, say 3%. This means that for every dollar you contribute, up to 3%, your employer will contribute another dollar. This example is a 100% return on your investment and must be taken advantage of. Other employers will contribute a set amount regardless of if the employee makes contributions. Some do both! But some do neither. It is fully up to the employer to decide.
Something that could be included as a benefit and a negative of the 401(k) plan is the ability for the participant to choose where their money is invested. This is great for the participant who is passionate about a certain industry or sector and wants to invest in it. But for some, this decision is stressful as they don’t want to make the “wrong” decision by investing in a subpar fund. It is not an easy decision but by investing in a low cost fund which tracks the market, you will set yourself up for success!
Drawbacks to the 401(k) Plan
There are drawbacks to the 401(k) plan, many which have already been mentioned. Choosing your investments can be a challenging experience, especially when you have limited investing knowledge. Even if you are knowledgeable about investing, there may be limited investment options in your plan.
The 401(k) plan, which comes with a cheaper price tag to employers than the traditional pension plan, has all but killed the pension plan market. Per CNN Money, only 4% of employees in the private sector have access to only a pension plan, down from 60% in the early 1980s. That is quite the downfall!
High fees are quite the problem with 401(k) plans. If you aren’t careful and pick the wrong investments, your investment gains could be bogged down by all the fees you pay. See the example below:
The example above shows the growth from a monthly investment of $500 over 30 years at a 7% return. The only difference is the fees paid. The high fee line is a 1% per year fee while the low fee is .10%. This all goes back to compounding. If you are in the high fee fund, you will have $114,050 less after 30 years than the low fee fund, or over 15%! Make sure you read the fine print on those funds!
The last issue with 401(k) plans are the early withdrawal fees. The plans are called retirement plans for a reason! If you withdraw money before you are 59 and a half, with some exceptions, you will get hit with withdrawal fees. These fees are 10% on top of the taxes you must pay on your withdrawal. That will add up real fast!
How the 401(k) Plan Works
The 401(k) plan is set up by the employer. They have final say on how the plan is designed, including how much, if any, the employer will contribute and which investments are available to the participants of the plan. Once developed, there is minimal work involved for the employer. The employer does need to follow the rules of the Employee Retirement Income Security Act of 1974 (ERISA) which was developed to help protect employee retirement plans.
Once set up, it then becomes up to the employee to make most decisions regarding their participation in the plan. First, they decide how much they would like to contribute. For 2020, maximum contributions can be made up to $19,500 or $26,000 if you are 50 or older at any time during the plan year. After contributions are determined, it is time for the participant to determine the funds they would like their money invested. After that, you just let it be and watch your money grow!
Retirement is Here!
So you have been consistently contributing to your 401(k) over the years, receiving a bunch of employer match contributions along the way. You have finally decided enough is enough, and you are ready to start taking contributions! First of all, congratulations! That is a huge milestone worth celebrating. But what happens next. What are the rules.
The first step is determining what type of plan you were in. If you were investing in a traditional 401(k) plan, it has come time for old Uncle Sam to claim his tax revenue. If you were in a Roth 401(k) plan, you have already paid your due. We will assume you are in a traditional 401(k) plan as that is what the majority of plans are.
When you withdraw money from your 401(k), it is taxed at your ordinary income tax rate and subject to the income tax brackets set by the IRS. These are set to change each year so stay current! What does this mean? Make sure to keep some of your withdrawal to pay your taxes when they come due!
What is Your Action Plan?
After reading this, I want you to log onto your 401(k) providers website and review your options. First off, how much are you contributing? Are you at least contributing enough to get the full employer match? If not, up your savings rate NOW. That is free money you are throwing away. You wouldn’t throw away a $100 bill you find on the ground would you?
Next off, take a look at your investment options. Are you investing in a high fee fund? If so, you might want to think about changing your investments to lower cost options. Those fees will add up and drag you down.
The last thing you need to do is let time work its magic. Once you have your settings in place, let it build. The only thing you need to do is think about increasing your contributions over time, until you get to the max. Do whatever you can to never take a loan or an early withdrawal from your balance. These can destroy your retirement dreams with one move.
As I have said many times, time is your greatest ally here. The longer your money is growing within the plan, the more you will have when it is time to enjoy it. Start early and get those gains adding up. Your retirement dreams are what’s at stake!