Personal Finance Topics Retirement: What is a Traditional 401k?

Retirement: What is a Traditional 401k?

Beach Picture
Like this…but with lots of tourists. Image courtesy of funcrisp.com

Imagine you’re on a nice beach in Florida without a care in the world.  Do you feel the soft breeze on your skin and hear the soft crashing waves on the shore and the tropical birds chirp in the distance? This could be what retirement feels like.  On the other hand imagine having to reach out to your children for help in paying your hospital bills as you didn’t realize health care costs could become so expensive. You have to keep working because you don’t think you can afford to lose your income stream. This could also be retirement feels like. I bring up these opposing visions to illustrate a simple point: retirement is a big deal.

In the next few posts I will be discussing the various retirement plans  available and how to make the most of the dollars you earn today.  It is never too early to think about retirement.  As I mentioned in Lesson 1 there is a benefit in investing today and not fifty years down the line.

Let’s begin with one of the most common terms in the world of retirement plans: the 401k. I will note that most people will be able to use a traditional 401k plan. There are some exceptions including employees of the government or nonprofit plans which I will address in later posts.

Key Points

  • A traditional 401k is an elective retirement plan which grants an employee the ability to defer some of his/her earned income in order to obtain current favorable tax treatment.
  • The benefits of using a traditional 401k plan include favorable tax treatment and employee matching.
  • The limitations of a traditional 401k plan include distribution limits, contribution limits, and later taxation.

What is a 401k plan?

Put simply a 401k plan is a retirement plan an employee enrolls in through his or her employer. There is a tax benefit associated with contributing to a 401k plan and in addition the employer generally will match the employee’s contribution according to some predetermined formula.

In general the company offering the 401k plan does not manage the plan.  It usually serves the role of the sponsor of the plan. To think of it differently, the sponsor of the plan (the company you work for) usually outsources the management of the plan to a financial service company who you contact for the actual management of your plan.  The identity of the financial service company that manages your 401k plan should be detailed in the benefit guide of your employer.  The role of the employer as the sponsor is to pay for the setup of the plan and to make matching employer contributions according to some formula.

A very important term to become familiar with is the term elective deferral. An elective deferral is simply the portion of your paycheck that you are choosing to put into the 401k.

What are the benefits of a 401k Plan?

So why would I want to tell my employer to funnel some of my earnings into my 401k plan instead of putting that money in my pocket? There are two main reasons: tax treatment and contribution matches from your employer.

1. Tax treatment: Taxes suck. Luckily the 401k provides a way to decrease your federal income tax payable.   Your elective deferrals do not show up as taxable income. Said differently the income you choose to defer (put off until retirement) does not count as your taxable income in a given year.   The federal government is rewarding you for investing in your retirement.

IRS Soldier
“Did someone say that taxes suck?” Image courtesy of offthegridnews.com

 

If you think this sounds too good to be true, you’re correct. Though these contributions are allowed to grow untaxed in the fund, when you withdraw the funds (also called a distribution) they are subject to taxes as ordinary income.  An example would be if you have invested in a 401k plan and at age 65 withdraw $50,000 from the plan, this $50,000 would be reflected as ordinary income and subject to taxes.

2. Employer matches: Who likes free money?   By contributing to a 401k plan, this is a possibility.  Most corporations as part as their benefit package offer “401k-matching”. What this means is based on a predetermined formula your employer will contribute to your 401k fund. For example a company may match 25% of your contributions up to $2,500 per year.  Meaning for every $1.00 I set aside in the fund my company will contribute $0.25.  Getting paid for investing in your retirement is a pretty neat thing.

PFT Retirement Plans Traditional 401k Vest Pic
Vesting is surprisingly not related to clothing. Image courtesy of honeybuy.com

There are some caveats to be aware of.  While you always have a claim to the money you contribute to the plan, you may not always be able to have total claim to the employer’s contributions.  Many companies enact a vesting condition in their contributions. Vesting refers to an amount of time that must pass before you have claim to some asset.  This is generally done to ensure you will remain employed by that company for a longer period of time. An example of a vesting schedule would be that you vest 100% in the company’s contributions after five years with vesting beginning at 20% in year one and increasing by 20% each subsequent year.

Let’s use a quick example.  Say John Galt works for Eos Inc.  and Eos has a 25% matching contribution and the vesting schedule is 20% each year for the first five years at the company.  Mr. Galt has been working at the company for three years and contribute $5,000 to the 401k plan each of those years. How much principal does Mr. Galt have claim to (assuming the fund did not earn a return)?

 

John Galt’s contribution to the plan:

3 years * $5,000 = $15,000

Eos Inc.’s contribution:

3 years * 20% of our $5,000 yearly contribution * 60% vesting limit

3 * $1000 * 0.60 = $1,800

Total principal in the fund = $15,000 + $1,800 = $16,800

Limitations of a 401k Plan?

1. Distribution Limitations: Waiting is hard.  At some point that $15,000 may look very tempting to withdraw and go spend on a new boat. Unfortunately the IRS would rather you not blow your 401k and has put in place deterrents to discourage that action.  The deterrent takes the form of a 10% additional tax if you receive the distribution before age 59 ½.  The reasoning is sound. The 401k is to provide you with retirement income, not a boat.

That being said the ways the elective deferrals can be distributed without incurring additional charges include: you die, become disabled, or become unemployed; your employer terminates the 401k plan; you reach age 59 1/2  or incur significant financial hardship.

2. Contribution Limitations: There are two annual limits that every 401k owner should be aware of:

1. The limit on the amount you as an employee contribute to the plan 2. The limit on the total amount that can be contributed to the plan.

The annual contribution limit for the employee in 2015 is $18,000.  This ceiling has increased in increments of $500 for some years and is expected to so as the IRS adjusts it for costs of living and inflation.The annual total of elective deferrals and employer matching contributions cannot be greater than $52,000 or 100% of your compensation, whichever is less.

3. Later Taxation: As I mentioned earlier, the funds in the 401k plan can’t avoid the tax man forever.  When the funds are distributed to you (and hopefully not with the added 10% tax) these distributions will show up on your taxable income.

IRS Soldier
“Did someone say Tax Man?” Image courtesy of offthegridnews.com

An Example

For a comprehensive example let’s return to Mr. Galt who works at Eos Inc.  Mr. Galt has been contributing the $5,000 per year and has been matched by his employer 20% of his contribution.  Assuming that Mr. Galt has been working for Eos for 30 years the principal of his 401k alone is worth $180,000 before taxes. That’s not bad, but the neat thing about that number is it’s grossly underestimating the value of the 401k. Why? The money in the 401k has been invested in stocks, bonds, and other assets depending on the risk Mr. Galt took on.  If we assume that he earned a 5% average return over that time period the value of his 401k is not $180,000…it’s around $400,000 before taxes.

Conclusion

Senior couple
Pictured: Golden Years. Image courtesy of gainesvilletoday.com

Retirement is important to everyone.  Why should someone start early? Growth. What may not be clear is that your 401k will allow you to allocate and invest the funds as you choose. Said differently a 401k is just another type of account for saving and investing, but with an emphasis on retirement.  If done correctly, your fund can grow quite dramatically over the years of employment and you won’t have to worry about money when you reach your golden years.

In the next few posts I will be discussing other retirement plans that exist including the Roth 401k, IRA, and Roth IRA.

Definitions

  1. 401(k): A type of retirement fund which allows employees to defer funds in order to obtain favorable tax treatment and to obtain matching employer contributions.
  2. Sponsor: The employer who contributes funds and facilitates the participation in a 401k plan by its employees.
  3. Elective Deferral: A portion of earned income that an employee chooses to defer by transferring into a 401k and which does not contribute to taxable income in the year earned.
  4. Vesting: The process by which an employee accrues certain rights or privileges from his/her employer.

Further Reading

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