A 401(k) plan is an employer-sponsored retirement savings plan that allows an employee to contribute a portion of his or her paycheck into a tax-advantaged investment account. The employee typically chooses from a range of investment options within the 401(k) plan. These options, which often include mutual funds, are chosen by the plan sponsor. Approximately half of all assets in 401(k) plans are invested in mutual funds, which in turn are invested in stocks, bonds, and short-term investments. Some employers also allow options to individual stocks in their 401(K) plans.
These are the following types of 401(K) plans typically offered by employers.
1. Traditional 401(k)
In a traditional 401(k) plan account, taxes are deferred on an employee’s contributions; i.e., the contribution is taken out of an employee’s paycheck before taxes and is only taxed when it is withdrawn from the 401(k) account, usually during retirement. Because contributions are tax-deferred, they lower an employee’s taxable income in the year of the contribution. It’s an excellent way to lower your taxable income.
E.g., If an employee contributes $5,000 to a 401(k) plan in any given year, the employee is taxed on his or her income for that year excluding $5,000, because the employer took out the $5,000 before taxes. Investment returns in a traditional 401(k) plan account, such as dividends or investment returns, are not taxed as they are reinvested into the account.
Note – Early withdrawals – before age 59½—generally also are subject to a 10 percent tax penalty.
2. Roth 401K
This was added in the year 2006 and is not a mandatory feature offered by every 401(K) plan. For a Roth 401(k) plan account, the tax treatment is different. The employee’s contribution to a Roth 401(k) plan account is not given any tax rebate since it is paid for with after-tax dollars. Contributions and investment returns are then withdrawn tax-free in retirement, as long as the participant is 59½ years old and has had the Roth 401(k) plan for at least five years.
E.g. If an employee wants to contribute the maximum allowed $19,000 (for 2019) to a Roth 401(k) plan, then it usually costs more than $19,000 to the employee including taxes. So if you plan to make a Roth 401(K) contribution, make sure you take this into account. If you are in a high-income tax bracket, double check if it makes sense to forgo the tax benefit.
Note – Withdrawals of investment returns are subject to income tax and possibly a 10 percent tax penalty.
3. After Tax 401K
For an after-tax 401(k) account, the tax treatment is slightly different than a Roth 401(K) account. The employee’s contribution to an after-tax 401(k) account is not taxed or tax-free upon distribution. However, the gains are tax-deferred and taxed as ordinary income upon distribution. As of 2019, the maximum allowed amount in an after-tax 401(K) is $56,000.
You need to be aware of these things before you get all excited about this option.
- Your 401(k) plan at work needs to allow non-Roth, after-tax contribution in the first place. Not all retirement plans do.
- In order to take maximum advantage of this strategy, your 401(k) plan needs to allow you to convert your after-tax contribution to a Roth IRA while you are still working for the company. Some plans only let you do it after you leave, which means any gains you earn on your after-tax contributions before the conversion will be taxed as ordinary income upon distribution.
- Before considering this strategy, max out pre-tax and/or Roth 401(k), IRAs and Health Savings Accounts (HSAs) contributions if applicable.
How Good Is Your 401(K) Plan?
Given the tax advantages a 401(K) plan offers, it’s no surprise that it is being used extensively by Americans as their de-facto retirement savings vehicle. With all the tax incentives it provides both for pre-tax and on the gains, to both employers and employees it makes sense to dive deep to understand your 401K plan offered at work. So let’s take a look at some of the key indicators that reveal the quality of your 401K plan.
1. Low Cost Investment Options
According to this report, the average 401(K) plan has 22 investment options. This has been consistent across the plans irrespective of the size of the plan. One of the key things to look for in a retirement plan is the investment options. At a minimum, you need have the following types of investment options.
- Target Date Retirement Funds
- Equity Funds By Market Cap
- International Funds
- Low-cost Broad-based Index Funds
- Bond Funds
Once you have a good mix of the funds I have listed above, look for the overall costs associated with these individual investment options. A good retirement plan could have an overall cost of 0.1% – 0.75%. On the higher side, there are plans which have an average fee of about 1%-2%. These fees may seem nothing, but over time can really eat away a huge chunk of your nest egg.
e.g. Consider a 25-year-old who has $25,000 in a retirement account, adds $10,000 to the account every year, earns a 7% average annual return and plans to retire in 40 years. 1% in fees would cost a millennial more than $590,000 in sacrificed returns over 40 years of saving.
2. Generous Employer Match
This is literally free money, please don’t leave it on the table. According to this article, 43% of employees said the company match was the primary reason they participate in the plan. So whether you decide to contribute to a Roth 401(K) or a pre-tax 401(K),
According to another article, The Bureau of Labor statistics indicate that the average employer 401(k) matching contribution is approximately 3.5 percent of the employee’s annual compensation; the median matching contribution is approximately 3 percent. A breakdown of the statistics is as follows:
- 10% of employers provide a 401(k) matching contribution of greater or equal to 6% of annual compensation.
- 41% of employers provide a 401(k) matching contribution that falls in the range of 0-6%
- 49% of employers do not provide employees with any 401(k) match.
In some industries like Tech, companies like Microsoft have very generous employer matches, where you get 50% of the maximum allowed federal limits for a 401(K). It can be a lot of money. E.g. For 2019, if you are under the age of 50 years, you can look at approximately $27,500, if you choose to max out your 401(K) contributions.
In some rare cases, an employer does a dollar to dollar match for every dollar you contribute to your 401(K) plan. Sadly, such employers are not a majority.
Note: Any employer match you receive will always get added to your Traditional 401(K) account since it’s pre-tax money, even though you might be contributing to a Roth 401(K).
3. Immediate Vesting
Did you know that only 22% of the existing 401(K) plans allow immediate vesting? Not every employer is generous to offer such a vesting schedule. Below are some of the common vesting schedules in a typical 401(K) plan.
- Cliff Vesting Schedule – This plan requires you to stay with an employer for a minimum number of years, or you don’t get any of the matches.
- Graded Vesting Schedule – This plan offers to slowly vest the match with every year of service until you hit 100% (usually at 3-5 years).
- Waiting Period To Become Eligible To Participate – Some employer 401(K) plans can be as ridiculous as to not even allow you to contribute to the plan unless you’ve been with an employer for a minimum of a year. You don’t have the ‘privilege’ of contributing YOUR own money to YOUR own retirement account, until after a year at some employers.
If you are on an immediate vesting 401(K) plan, you’ve got the best deal possible.
4. Option To Borrow Against Your 401(K)
First things first. I had previously written about this and it’s my firm belief that you should never borrow against your 401(K).
Most of the times, I have seen people taking out loans against their 401(K) plans, all in the name of ‘repaying’ themselves to pay for a downpayment or some other event. I have included this in the list, not because I think having a feature like this makes a 401(K) plan better, but instead, it encourages bad behavior. Do yourself a favor and don’t steal from your own future.
E.g. According to this NBER article, the researchers find that if the plan sponsor allows employees to take out multiple loans, the probability that participants take out a new loan rises by 2.7 percentage points, or nearly twice the mean rate of 1.4 percent.
What stands out in the report is the 86% of employees who change jobs still carried an outstanding 401(K) loan balance. In some cases, the payback period is typically between 30-90 days, failing which the entire loan amount will be treated an early withdrawal and be subject to penalties and taxes. So it’s a very high-risk strategy to borrow against your 401(K). Tread with caution.
Note – Allowing employees to borrow against their 401(K) is not a mandatory feature of a 401(K) plan and hence is purely at the discretion of the plan sponsor. If your employer has chosen to allow this, please think carefully before exercising this option.
If you are curios to know how good is you employer sponsored 401(K) plan, check out BrightScope.