Approximately 60% of employees contribute to their employer’s 401k! The common reason stated for not contributing is a lack of understanding. In fact, even a majority of those that contribute say they don’t understand. Therefore, this article is a 401k explanation for beginners and will take you one step closer to managing your money wisely.
Specifically, this 401k explanation is for students and new grads… and those that may have been working for a few years and still don’t understand their 401k. I included our 401k explanation for beginners video below which goes into details regarding matching and vesting.
What Is A 401k Plan In Simple Terms?
A 401k is a retirement plan offered by employers. You choose how much to automatically contribute from your paycheck and you choose the investments. You are not taxed on the money until you take it out of the account.
However, if you withdraw the money before 59.5 years old, you must pay an additional tax penalty.
How Does A 401k Grow?
Your 401k grows four ways:
- Your contributions
- Your employers matching contributions
- Growth of your investments
- Reinvestments of dividends and interest earned by your investments
For beginners that are just starting their 401k, most of the growth will come from your contributions and your employers matching contributions. That is one reason why we at FitBUX highly recommend contributing enough to your 401k to maximize your employer match.
Matching language used by your employer is important for beginners to understand. Therefore, I dive deeper into it below.
401k Matching Explained
If you contribute to your 401k, your employer may match your contribution. The most common match is 100% up to some percentage of your income. Words of advice… we (FitBUX and myself) highly recommend contributing to your 401k at least the amount to get your match. Its free money!
To explain how it works, I will use the following figures to provide an example:
- You make $70k per year
- Your employer states, “We match 100% up to 3%”
This means if you contribute $2,100 per year to your 401k your employer will also put in $2,100. If you put in $5,000 a year, they will still only put in $2,100 because that is 3% of your income.
Partial Matching Explained
The next 401k explanation centers around partial matching. Let’s pretend you are making $70k per year like the example above.
However, your employer now states, “We match 50% up to 6%.”
This means if you contribute $4,200 to your 401k per year, your employer will put in 50% of that or $2,100. If you put in more, let’s say $5,000 a year, your employer will still only put in $2,100.
Additional Matching Language
The last matching language explained in this article is the one that confuses people the most. They 1) don’t know how to interpret the language and 2) they don’t know what they have to contribute to get the full match.
This situation is simply a combination of the first two matches explained above. The way its worded is the following, “We match 100% up to 3% and 50% up to 6%.”
Again, let’s assume you make $70k per year. If you contribute $2,100 to your 401k, your employer will match the full $2,100. If you contribute another $2,100, they will do an additional $1,050. Therefore, if you contribute $4,200 a year, your employer will contribute $3,150. Thus, to get your full match in this scenario, you would need to contribute $4,200 per year. If you contributed more, let’s say $10,000 per year, your employer would only match $3,150.
The last 401k explanation I’ll provide in this article is vesting. Vesting basically means how long you have to be employed before the employer match belongs to you.
Most 401ks vest immediately. This means as soon as your employer contributes to your 401k, you own that money!
However, some will have a vesting schedule. For example, let’s say your employer says there is a 4 year vesting schedule. In addition, your employer match $2,000 per year.
This means that the $2,000 is not your immediately. Instead, for each year of work you complete, you receive $500 of it.
What Do You Want
The optimal situation would be to have a company that matches a high percentage of your income (3% or more), match 100%, and have 100% immediate vesting.
I also get asked by new grads if they should pay off student loans or invest. Any type of match is beneficial and you should always do what you can to get the minimum match.
In the video above, I provide a few examples on how much more you get with a match vs not having a match. In addition, I provide some examples of how you can compare job offers between companies offering you different salary amounts and retirement benefits.
Also, if you would like more financial advice for young adults in addition to getting your match, be sure to check out this article. It discusses things you can do behaviorally to put yourself in a good position.
What Is The Average Return On A 401k?
There is no such thing as a return on a 401k. A 401k is an account type your put money into that has a special tax law associated with it. The return you earn will be based on how you choose to invest your money.
Remember, manage your risk and your return will be there. Want more info on how you should invest your money? Check out this investment webinar for young professionals.
What Happens To My 401k When I Quit?
You have 4 options with your 401k when you no longer work for an employer:
- Do a 401k rollover (Recommended)
- Leave it in the old 401k
- Move it to your new employer if they offer a 401k
- Withdraw the money (Only do this in worst case scenarios)
How Much Should I Contribute To My 401K?
At a minimum, you should contribute the amount needed to maximize your employer match. After that, it depends on your other financial goals as well as your current tax bracket.
For example, instead of contributing more than the amount needed to get your match in a 401k, you may want to contribute to a Roth IRA based on your tax situation.
To figure out exactly how much you should contribute, be sure to use FitBUX’s financial planning technology. You can build multiple plans then simulate and compare your options. Plus, you can schedule a free call with a FitBUX Coach and they can answer your questions.
Below are a list of rules that you should be aware of when it comes to 401k(k)s.
- You, as an employee, can contribute $20,500 per year before taxes.
- You can make further contributions up to $61,000 per year but these contributions will be taxed in that tax year.
- People over age 50 can contribute an additional $6,500 before taxes each year.
What are the rules for 401k withdrawals?
- You can take money out of your 401(k) without penalty once you reach 59.5 years old.
- You can take money out of your 401(k) early for certain disabilities.
- 401k contributions are pre-tax. Roth 401k contributions are after-taxes.
- At age 72 you are required to take minimum distributions called RMDs
- You may us the Rule of 55 to take money out early and not pay a penalty
- There are no penalties or taxes if you rollover your 401k to a traditional IRA
What are the costs of early 401k withdrawals?
- Federal income tax at your marginal tax rate
- 10% penalty on the amount you withdraw
- State income tax
- There are some penalty-free exceptions for withdrawals but you still have to pay income taxes on them
- Not all employer plans allow loans and they aren’t required to do so
- The employer sets the terms of the loan.
- Maximum loan amounts are $50,000 or half of your 401k’s vested balance
- Generally the maximum term is 5 years
- If the loan is for a down payment on a primary residence, the loan term can be as long as 15 years
- If you leave your employer, usually the loan is due within 60 – 90 days
- If you can’t repay the loan, you are assessed penalties by the IRS
More Retirement Resources For You
By Joseph Reinke, CFA