Retirement savings Part 2: 401k

This post is the second part in a multi-part series about saving for retirement. Part 1 which introduced employer sponsored retirement savings plans aka 401k plans can be found here:

Traditional 401k plan

Contributions: Once you decide how much money you want to save towards retirement, you normally fill out a paper form/ make elections online and the specified contributions are withheld from your paycheck. Since the contributions are pre-tax, this amount is subtracted from your salary before taxes are withheld. Why is this important? Suppose you decide you want to save $1000 towards retirement and you earn $3000 (@ 20% tax bracket). Before you make these contributions, you will get 2400$ in hand (80% of 3000) and pay $600 tax. After you make the contribution, your taxable income becomes 2000$ (3000–1000) and you get 1600$ in hand (80% of 2000), pay only $400 tax. You avoided the tax that you would have paid on your contribution (20% of $1000 = $200). So you save 1000$ in your 401k account but your take home pay is only 800$ lesser.

Contribution limits: Every year the IRS publishes a limit on how much you can contribute to a 401k account. The elective deferrals limit is the maximum amount you as the employee can elect to contribute. In the above example your elective deferral is 1000$. For 2017, the elective deferrals limit is 18000$. This limit does not include any contributions made by the employer. There is however a total limit on all contributions for a year which for 2018 is lesser of 56000$ or 100% of compensation. Adults who are over 50 have higher limits than those specified above to allow catch-up contributions.

Investing your savings: Almost all 401k plans allow you to invest in a select list of funds. The combination of funds you select or your portfolio depends on your financial needs. As a general rule of thumb, if you are younger it makes sense to have a larger percentage of funds that are high risk, high return. While it is easy to just set up some allocation and forget about it, it is beneficial to check in once in a while and re-balance your portfolio if needed. One common mistake people do is to never make a selection and go with the default selection. In many cases the default selection might not be the right one for you or might have a higher expense ratio than a similar alternative fund.

Impact due to job change: A question that arises in everyone’s mind is what happens to your 401k account when you move to a new job. You can move the funds into a new 401k account with your new employer or into an IRA. This process is known as “rolling over” your 401k and your savings continue to grow in the new account.

Withdrawals: If you are under 59.5 years when you withdraw from your 401k plan, you need to pay a 10% penalty on your withdrawal in addition to paying taxes on these distributions. One exception to this rule is if you are in the age range 55–59.5 and you retired at or after 55 years; then you can start taking distributions penalty free. If you are over 70.5 years you are required to take distributions. Most of these rules have minor exceptions (which I am not getting into) but don’t apply in most cases.

If you have a financial emergency and you need to access the funds in your plan you can take a loan from it. This is a 401k loan where you are borrowing from yourself.

Roth 401k plan

A roth 401k plan is very similar to the the traditional 401k plan except for these key differences:

Contributions: The contributions to a roth account are after tax contributions. So if you want to contribute 1000$ to your roth account, it will reduce your take home pay by 1000$. You do not get any tax benefits while making the contribution .

Contribution limits: The above mentioned annual contribution limits are for the combined contributions between roth and traditional 401k accounts.

Withdrawals: The withdrawal rules for a roth account are different compared to a traditional account. If you are over 59.5 years and have had the account for 5 years, then the distributions are qualified and they can be withdrawn tax free and penalty free. If the distributions are not qualified, you pay tax and penalty on the “earnings portion” of your account since the contributions came from after tax dollars. e.g. Assume you contributed $9000 and your earnings in the account are $1000. So your contribution to earning ratio is 9:1 in your roth account. If you withdraw $500 from this account, it is treated as withdrawing $450 from your contribution and $50 from your earnings (9:1 ratio). So you will pay taxes and a 10% penalty on $50.

Employer match: It is important to remember that even if you contribute to a roth 401k account with after tax dollars, the employer’s contributions when they match your contributions will go to a traditional account. This is an IRS regulation.