Complete Guide to the 401(k) Retirement Plan

Do you like being stuck between a rock and a carrot? 🥕

A strange question, true, but 401(k)s are in a really weird place where they are both a painful opportunity and a delicious hassle. On the one hand, they not only let you invest far more money on a yearly basis than an IRA but also make sure your employer matches some—or all—of your contribution as well.

For this reason, they are often likened to free money. However, they also don’t guarantee that said free money will be yours immediately, or sometimes ever. In fact, only about 28% of companies make their contributions to employee property immediately.

Furthermore, 401(k)s are tax-advantaged and can really help you stop the IRS from taking too much of your money—but they also tend to come with far higher fees than going through a modern-day online broker’s retail account.

In a similar vein, funds under these plans are so hard to access that they may at times appear like someone else’s money, but these safeguards also guarantee that you don’t cannibalize your savings prematurely.

So, let’s take a deep breath and make a thorough investigation of why you should invest in 401(k)s, and how to get the most out of these plans. 🔍

What is a 401(k) Plan?🤔

401(k) plans are employer-sponsored tax-advantaged retirement funds. The basic idea traces its roots to the early ‘70s and the name to the 1978 addition to the code of the Internal Revenue Service—section 401(k).

The gist of these plans is that they allow the employee to park a portion of their earnings in a retirement fund and the employer to make further contributions to such funds. Individual contributions are capped at $19,500 per year for people under 50 and $26,000 for those above that age.

In turn, employer contributions are capped at $58,000 if the employee is younger than 50, and $64,000 if they are over said age. These numbers are valid for 2021 but are likely to rise in the future as they are adjusted based on inflation, which is expected to rise even more. In most cases, employers will match their worker’s contributions either dollar for dollar or 50 cents for a dollar. 

How Does a 401(k) Plan Work? 👔

There are two more major caveats of 401(k) plans. The first being that upon reaching the age of 72, you will have to start withdrawing money from the fund even if you are still working. The second is that the employer can only contribute to the taxable-on-withdrawal traditional 401(k).

You should also note that there are no capital gains taxes on investments made both through traditional and Roth 401(k)—a very nice bonus as taxes on stocks trading can get very costly if you are not careful.

What is a Roth 401(k)? 💭

A Roth 401(k) is a variant of 401(k) plans made available in 2006 on the initiative of rep. William Roth of the Roth IRA fame. The main feature of these plans is that employee contributions are made after the year’s taxes are paid—meaning that the money isn’t taxable upon withdrawal.

This variant of the plan is especially beneficial for people who are in a lower tax bracket and early in their career—thus expecting significant pay rises in the future which would make their taxes higher when retiring.

The chief difference between the two types of 401(k) is whether contributions are made before, or after the taxes are paid—the first option meaning that money withdrawn upon retirement will be taxable.

Either way, money put into a 401(k) will be further invested meaning that in almost all cases you will retire with more money than you contributed to the fund. Mind though that while an employee has to decide how the money will be invested, they are still limited by the options given by the employer.

What is a Safe Harbor 401(k)? 🛡️

Safe harbor 401(k) plans have grown rather popular as they allow a company to automatically pass compliance tests with regards to non-discrimination and top-heaviness. Non-discrimination deals with IRS’s standards ensuring that the plan offered is equitable to all employees, while the other one makes sure that highest-paid workers aren’t getting a disproportionate, lion’s share of contributions.

Safe harbor 401(k)s come in three distinct flavors—enhanced match elective, basic match elective, and non-elective.

If the company picks basic match elective it means they will match 100% of employee contributions up to a limit of 3% of worker’s total compensation—and an additional 50% for the next 2% of total compensation.

Enhanced match elective is rather similar though a bit more straightforward—the company will match 100% of employee 401(k) contributions up to 4% of their compensation.

Non-elective means that a company will contribute 3% of an employee’s total compensation to their 401(k) plan regardless of the worker’s contributions.

One immediately obvious benefit of safe harbor 401(k) plans is that since fewer yearly tests have to be taken, the total operational costs will be lower on that front. The drawback of these plans is that they are tied to strict deadlines—all paperwork has to be compiled and filed by December 1st of any given year—and they are by their nature year-long financial commitments.

Another perhaps overlooked liability of safe harbor 401(k)s is that their termination sometimes comes with a fee.

What is the Difference Between an IRA and a 401(k)? ⚖️

As we’ve already established, 401(k) plans are offered by employers. On the other hand, opening an individual retirement fund is something anyone can do, usually simply by picking among the top IRA brokers and going through their registration processes.

Furthermore, while you may think that individual IRAs are no longer worth the hassle due to factors like even companies such as McDonald’s now offering 401(k) plans to new employees as an incentive, that simply isn’t true. To begin with, unless you stay with the same employer for the entirety of your career, you’ll probably have to open an IRA.

This still doesn’t mean that 401(k) plans are not worth it. They allow significantly higher annual contributions than IRAs—$19,500 as opposed to $6,000. This is, of course, on top of the employer contributions which essentially constitute free money.

On the other hand, individual retirement funds do boast lower fees and a wider selection of investments which might just make them a superior option—as long as you have the time, energy, and the know-how to make the most out of investing.

Additionally, while employers matching employee contributions is wonderful in theory, in practice it usually takes a long while for that money to really become yours. This is called vesting, and means that you have to work for the same company for a while before you get to keep that money—which isn’t particularly good if unexpected problems at work arise, especially since they tend to make money tighter than usual.

What Happens to Your 401(k) When You Leave Your Job? 🧳

When you leave your job your 401(k) basically becomes dead in the water—with four main ways of getting it back up and working for you. Here they are.

Leaving the Fund 🛅

The first and simplest thing you can do is leave your account with your old employer. This usually requires the plan to have more than $5,000 under management—pretty much all companies force you to move your account if it is smaller than this.

The first big drawback of this option is that you can’t make further contributions to this plan. In turn, it means that you can’t use the money you’ve already saved up in a 401(k) for future investments with your retirement fund—which can stifle your overall returns.

The second, perhaps more surprising drawback of this approach is that many 401(k) accounts simply get forgotten. Americans lost as much as $1 trillion to old, unremembered 401(k) plans over the years.

Withdrawing the Money 💰

Another very straightforward way of dealing with your old plan is to simply withdraw cash upon leaving a job. This, however, is also a bad idea in a vast majority of cases. To begin with, unless you are 59 1/2, or older, there are severe penalties to doing this.

Unless you are withdrawing from a Roth 401(k), the money will be taxable along with the rest of your income for that year. Additionally, you will have to pay a fee of 10% for early distribution.

Note though that these penalties have been relaxed and suspended greatly during the covid-19 pandemic as a part of the CARES Act. This still doesn’t mean that withdrawing money from your fund early should be anything but a last resort—lessening your retirement savings can come back to haunt you in your old age.

Keeping Your 401(k) with a New Employer ✅

This begs the question if there is a good way out when changing jobs and the answer is, thankfully, yes. The first of these good options is transferring your 401(k) from your old employer to the new one.

Such a move is possible only if your new employer allows for it and is especially beneficial if you aren’t comfortable with taking full responsibility for your retirement fund and its investments through an IRA. 

It also maintains the tax-advantaged status of your fund and if you are nearing the age of 72 this move can protect pretty much all of your money from additional taxation.

Rolling Over to an IRA 🧾

The last option you have is to rollover your 401(k) into an IRA. This is probably your best option if your new employer doesn’t allow you to transfer your old plan to them. Generally, it has a lot of benefits as it maintains both the tax-advantaged status of your assets and keeps the retirement fund mostly intact.

However, IRS has strict rules imposed on these rollovers, nonadherence to which will lead to you being both taxed and penalized for early distribution. While most new asset managers, usually the leading Roth IRA brokers will be more than happy to help the rollover go smoothly, we’ll still make a quick overview of these rules.

401(k) to IRA: How the Process Works ⚙️

There are two main types of a rollover—direct and indirect. In a direct rollover, a trustee sends a check to another trustee thus rolling over the 401(k) plan to either an IRA or a Roth IRA—all without hassle for you.

An indirect rollover is a more complicated—and less advisable option. In this case, you as an individual get the money from your previous employer with the obligation to put it into your tax-advantaged account—your IRA—within 60 days. If you don’t complete this within that time frame, the money is both taxable and penalized as an early distribution.

This option should generally only be considered if a direct rollover isn’t possible, or if you have large and immediate expenses—necessitating turning your retirement money into hard cash—and will be able to reimburse yourself before the 60-day grace period is over.

Two additional caveats of indirect rollovers are that you are limited to only one within 12 months and that it must be a transfer from a single account to a single account—you can’t rollover a 401(k) into multiple IRAs or other such accounts and plans.

How You Can Withdraw Money from Your 401(k) 👇

There are several ways you can withdraw money from your 401(k). First, and most obvious is if you want to start receiving that money as your pension at the earliest when you turn 59 ½, and at the latest after your 72nd birthday.

Under these circumstances, you can proceed as expected—without early distribution fees and without paying taxes if you were under a Roth 401(k). Under all other circumstances, another triggered event must first be satisfied for the funds to become available. These events include:

• ☑️ You retire or leave your job
• ☑️ You suffer a disability or pass away
• ☑️ The plan you are under gets terminated
• ☑️ You suffer some other hardship as defined by your plan

Mind that under nearly all circumstances except after reaching the age of 59 ½ you will be penalized for early withdrawals. These triggered events are conditions necessary for you to be at all able to access your money.

There is one more option that could be considered withdrawing money from a 401(k). Some employers allow you to loan up to $50,000 from your plan for 5 years. This limit isn’t entirely immovable as the repayment period is longer for primary home purchases. Additionally, the CARES Act has doubled the loanable amount to $100,000.

Still, as we’ve already stated, loaning and prematurely withdrawing money from your retirement funds should always be a last resort. Furthermore, it isn’t advisable to overly rely on the generosity of the CARES Act as—as was showcased with some benefits being terminated at the beginning of 2021—it might not be here to stay.

Benefits of Investing in a 401(k) 🤗

While it is easy to be blind-sighted by the offer of employer contributions to your 401(k)—especially now that some certainty is restored with companies like Exxon resuming their contributions after the 2020 lull—they are far from the only big benefit of these retirement plans. So, let’s take a look at some of the major ones.

Money for Nothing 💵

The first and most obvious benefit of a 401(k) plan is the employer match. You simply can’t beat the prospect of free money going toward your retirement. As an example, say you are earning $75,000 per year and your employer is matching your contributions dollar for dollar. 

Also, let’s say you are contributing 5% of your pay—$3,750. This makes the total yearly contribution to your 401(k) $7,500 as your boss is giving you an additional $3,750. Even if you get only 50 cents for each of your dollars the deal isn’t that bad—$1,825 in free money.

And Pension for (Almost) Free 🆓

401(k) plans are also tax-advantaged and tax-deferred. Once your money is under a plan you don’t have to worry about taxes until you retire—if you are using a Roth IRA not even then. The benefits of this can’t be overstated. 

Short-term capital gains taxes can be a real pain in the neck, for example, if you are investing in an aggressive actively managed mutual fund that might do a lot of transactions in quick succession.

The very special nature of Roth IRAs will likely only become even more important in the future. Since contributions in this fund are made with post-tax dollars, and the IRS can tax you only once for the same thing, all your gains over the years are completely safe from Uncle Sam.

As we’ve stated before, this feature of Roth IRA plans is especially good for those of you who expect to earn significantly more later in life. Tax brackets in the US range from 10% for those earning up to $9,875 to 37% for those earning more than $518,400.

The Importance of a Retirement Fund 💡

Sitting in a peculiar spot as both the most tangible and the most intangible benefit of 401(k)s is that it is a retirement fund. With all the covid-19 craziness—and even before the pandemic—giving adequate attention to your savings is never easy.

While the state governments are increasingly jumping on board with the idea of automatic IRAs for those without a retirement plan, you really shouldn’t rely entirely on that if you have a choice.

Considering that the average medical bills of a person over 65 in the US are about $11,000 per year, a solid pension fund is a massive boon even for those of you who aren’t dreaming of sailing the seven seas in your twilight years—and a true highlight for why you shouldn’t tap into your 401(k) early unless in the direst of straits.

Another really good long-run aspect of qualified retirement funds like the 401(k) is that they are protected by the Employee Retirement Income Security Act of 1974 (ERISA). This means that these savings are safe even if your finances otherwise crash and burn—creditors can’t touch them.

Drawbacks of Using a 401(k) 👎

While the benefits of using 401(k) plans are many, they are far from the be-all and end-all of funds. They have several drawbacks that—while far from making them bad in any sense of the word—merit consideration when plotting your investment and saving strategy.

Losing Control 😱

As we’ve discussed before, with 401(k)s you don’t always have access to your money—some conditions have to be met, and even then the chances are you are going to be penalized for early distribution.

Directly in contrast to this problem is that you might be forced to start withdrawing money before you want to do so. This is an issue since by the time this IRS provision is triggered you’ll be receiving social security benefits—and this combination of income can make you pay much more in taxes than you’d like.

Fees and Taxes 🏷️

The money you get from your retirement plan falls under ordinary income tax—which is higher than the long-term capital gains one. Roth 401(k)s somewhat help with this issue as they are filled with post-tax money, and the IRS can only tax you once for the same thing.

On the topic of paying more for your money, another issue of 401(k)s is their fees. Most of these plans come with a plethora of extra costs—administrative, investment, service—and they tend to be worse the smaller the company you are working for is. 

The percentages you appear to pay can be deceptive since even 1-2% fees can translate to thousands, or hundreds of thousands of dollars by the end of your career. The only real way to avoid this is to mix and match various investment and saving methods to min-max your costs.

Many of the top stock brokers charge you nothing, or next to nothing and can sometimes make even paying unfavorable taxes more cost-effective. Furthermore, such a hybrid style of investing can open doors for further creative strategies where you can even turn short-term losses into long-term gains through strategies like tax-loss harvesting.

A Narrow Road 🛣️

401(k) plans tend to offer only a relatively limited selection of ETFs and mutual funds to invest in. These can often be hit-or-miss as while these types of funds somewhat mitigate the limited selection offered through their inherent diversification, they also tend to be more expensive than others on the market.

As we’ve briefly touched upon already, even a 1% higher expense ratio can drive up the costs manifold. 

So, let’s say that you somehow managed to keep the same 401(k) plan throughout your entire 40-year-long career and that median expenses were 1.5% and total average monthly contributions were $1,000. Furthermore, let’s compare it to a plan with 0.5% expenses. Also, average 401(k) returns are between 3 and 8% so we’ll just put them at 5% here.

Another issue of a narrowed selection of investments is that it stifles your ability to capitalize on certain market trends and avoid any potential downturns. This, yet again, highlights that you can’t completely rely on your 401(k). You simply should also have an IRA, or a Roth IRA, and try to save some money from your regular investments toward your retirement.

That being said, the incorporation of cryptocurrency into 401(k) plans that is currently pushed for can increase their versatility significantly. Mind that—much like with the process of legalizing Bitcoin ETFs—this addition can turn out lengthy and complicated.

The Good and the Bad with 401(k)s

401(k) Investing Tips 🗣️

While 401(k) plans for the most part relieve you of having to pick a stock broker, you’d be imprudent to go in without any strategy. This need is twofold—there are some good steps to make sure that you are making the most from the money in the 401(k) itself, and others that ensure that you don’t overcommit, and know when to invest elsewhere.

The Big Picture 🖼️

The story of 401(k) investing is very similar to the overall story of playing the stock market. The first maxim you should follow is not to put all your eggs in the same basket. On one hand, it regards diversification as stated within modern portfolio theory—and ETFs and mutual funds will mostly have this covered within your 401(k).

The other side of this particular coin deals with the plans themselves. We’ve seen that 401(k) plans boast many advantages but also have some very serious downsides. Thus, you really shouldn’t rely too heavily on them.

Two best ways of achieving this are to start investing in stocks generally and open an IRA as quickly as possible. Numerous fees and expenses associated with 401(k) plans even make some doubt whether they make sense anymore or not.

Furthermore, seeing that 401(k) returns average between 3 and 8% while the S&P 500 has been around 15% so far in 2021. This discrepancy means that you should generally try and contribute enough that you get the full employer match and then move onto your IRAs and other investments. 

You can further increase your chances of good performance when investing by employing techniques like fundamental analysis to better allocate your funds. However, the use of these tools will be limited by how much control you have over your 401(k) plan’s investments.

Step by Step 👟

Companies offering 401(k) plans often have default savings rates. These tend to be low, and generally suboptimal—you should always check what these are when starting at a new company and see what you can do to tailor them to your needs, wants, and abilities.

The second thing to keep in mind is that your employer contributions aren’t automatically vested. This, in very simple terms, means that if you leave the company early, you don’t get to keep all (or any) of that free money. There isn’t a rule written in stone how long you have to be with an employer to get vested but is often 5, or 6 years.

Once you are vested, you can start considering a new job. If you choose to do so, remember that you can rollover your plan to a new employer or an IRA without penalties as long as you keep to the IRS rules we’ve outlined earlier.

Lastly, remember that you are aiming to maximize returns and minimize losses. Don’t withdraw money from your retirement plans unless you find yourself in a horrible financial situation. You’d be sabotaging your future self and incurring heavy penalization.

As long as you keep investing, your savings should keep growing, especially if you pick your trades carefully, and give due patience to understanding how the stock market works.

Conclusion 🏁

The advent of low and zero-cost online brokers has made 401(k)’s staying power dubious—the only real thing making them extra special being employer contributions. The pitfalls of these plans make them less of a no-brainer than the free money it offers would lead you to believe.

However, it is likely changes are on the horizon and the future of these plans could become more exciting now that the question of whether Bitcoin belongs in 401(k)s is being posed due to the crypto market’s inherent dynamism. Furthermore, even without this promising news, a seeming pitfall—the difficulty in reaching funds invested in these plans—can be a boon for your future that brings some certainty in an uncertain world, and might just be enough to make 401(k)s worth it on its own.

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