The Fundamentals of 401(k) Plans
What is a 401(k)?
The term 401(k) simply refers to the section of the Internal Revenue Code that defines the rules and regulations about these specific kinds of retirement savings plans. In a nutshell, a 401(k) is a special investment account that allows employees to contribute a percentage of their salary, pre-tax, exclusively to be stored away for retirement. While this may seem a little complicated, it breaks down into three defining features:
- Sponsored by an employer
- Earmarked for retirement
- Invested in the stock market
First and foremost, a 401(k) plan must be sponsored by an employer. While individual employees are the ones who participate in the plan, they can not set one up on their own. This is because, by definition, these tax-deferred plans are specifically set up to help businesses encourage their employees to save for retirement.
Second, these plans are specifically reserved for retirement. While there are certain instances in which you can withdraw money early from your account, they are only advisable under extreme circumstances and come with hefty penalties. The idea here is that people need a significant amount of money on which to live during retirement, and many don’t plan for that.
Finally, one of most misunderstood aspects of a 401(k) is that it is, in fact, an investment account. The money you put away into your account is an investment in the stock market, usually made up of mutual funds, stocks, bonds, money market funds, savings accounts, and other investment options. This is why it’s so critically to invest aggressively as early as you can.
April 27, 2016
How does a 401(k) work, exactly?
While it may seem straightforward, there are a lot of complex, moving pieces behind the administration of a 401(k). In its simplest form, here are the steps that happen in order to make the plan operate.
First, the employee determines how much she wants to contribute to her plan. This can be in the form of a percentage or a fixed dollar amount. When the employer processes payroll for a given period, the specified portion of her salary is withheld from her paycheck for the 401(k) plan. The funds are then sent to a function called a record keeper, who is in charge of investing it into the stock market according to the funds that the participant has selected.
The primary benefit of this sort of plan, and how the government incentivizes 401(k) plans, is that this money is now allowed to grow tax-free! While the actual return on the investment account will be determined by the market, the tax savings on any gains is a key driver in helping people save for their financial futures.
Pre-tax vs Post-tax contributions: what’s the difference and which should I choose?
People often talk about the difference between a traditional 401(k) and a Roth 401(k), and are confused about the differences. A Roth 401(k) can only be funded with post-tax dollars, while a traditional 401(k) is funded with pre-tax dollars. To illuminate the difference, let’s walk through an example.
Let’s imagine that every month, Josh receives a paycheck for $1,000, he is taxed at 20%, and decides to contribute 5% of his income to his 401(k) plan:
- With a traditional 401(k), the first thing that will happen is that 5% ($50) will be withheld from his paycheck for his 401(k). That money will then be deducted from his total pay, leaving $950 of taxable income. That $950 is taxed at 20%, leaving $760 in take-home pay.
- With a Roth 401(k), the first thing that will happen is the same: 5% ($50) will be withheld from his paycheck and be reserved for his 401(k). However, the difference here is that the 20% tax will be assessed on the entire $1,000, leaving $800. At the end of the day, Josh will take home $750 – the difference between his post-tax income ($800) and the $50 he put into his 401(k).
Note that if he chooses a Roth 401(k), he’ll take the hit upfront by making $10 less per take-home paycheck. But that’s only a short-term loss, because he won’t get taxed when he withdraws that $50 at retirement. In contrast, if he chooses the traditional route, he’ll have the short-term gain, but will be taxed on that $50 when he retires.
So, which one should he choose? While there’s no consensus, the general rule of thumb is that younger workers are better off with a Roth 401(k) because they are currently at a lower tax rate than they will be in the future. But every person’s situation varies, and there are other contributing factors that may influence your decision.
How much does a 401(k) cost?
Costs vary greatly from provider to provider, especially since many of them only offer certain services and are intentionally vague in their pricing. However, the costs associated with a 401(k) generally fall along the following lines:
- Asset-based fees – a fee charged on the total amount of money in a given plan.
- Per-person fees – a flat fee for each individual participating in the plan
- Transaction fees – a fee based on a specific action which can include a service or transaction
- Flat rate fees – a fee that does not change and is charged on a timely basis
Note that some of these fees apply to employers, some apply to employees, and some apply to both. For example, a company may choose to cover the cost of the per-person fees, but the asset-based fees may be charged to each individual employee based on his or her own amount. Additionally, there can also be hidden fees, so check out our guide on average fees here.
You may have heard about a new concept called robo-advising that many platforms are using. Essentially, the idea is that through automated, algorithm-driven investing, these new platforms are able to provide rock-bottom fees, market matching returns, annual rebalancing and on occasion, tax-loss harvesting.
For robo-advising to be effective, you set a your risk tolerance for your portfolio and allow the algorithm to adjust and make sure your preferences are constantly monitored and updated to keep the balance of funds that you have on par with what you initially set. By automating this process and not having a person manually update your funds, you can drive the fees that you pay down drastically.
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