Rowyn (rowyn) wrote,

401K: Another Lesson in Finance from Rowan

Postvixen pointed out in this entry that she didn't know what a 401k is. I'm guessing she probably doesn't want to know, either, but it struck me that there are probably people in my audience who don't know or don't really understand, and who would find an explanation helpful. And if I'm wrong, well, I didn't really feel like working on my novel anyway.

What is it?
A 401k is a retirement savings vehicle offered by employers to their employees.

When you enroll in a 401k, you set aside a certain amount or percentage of your salary to be contributed to the plan--maybe ten dollars a paycheck, or as much as 20% of your total salary. (Caps vary; Toddler Bank has a maximum of 15%. The maximum employee contribution allowed used to be $10,000, but it's gone up. Telnar would know what it is now, but anyone planning to put more than $10,000 to retirement almost certainly knows more than I am going to tell now, so I won't worry about it.)

This percentage of your salary is then invested in some range of financial products. What you can put it into is highly dependent on your employer, but typical options are mutual funds for stocks and/or bonds, money market accounts, and stock in your own company.

How do I get one?
Companies that have a 401k plan often don't offer it to employees until they have been employed for a certain amount of time--one year is pretty standard; two or three years is the maximum an employer can legally wait. Not all companies offer 401k plans.

Why would I want one?
Two main reasons:

Your employer may or may not offer a "match". Mine matches $.50 on the dollar for the first 3% of salary, and then $.25 on the dollar for the next 3%. So if I set aside 6% of my salary for my 401k, Toddler Bank will add 2.25% of my salary to that. This "employer match" money then does something screwy called "vest." Again, vesting varies from company to company. Toddler Bank vests theirs at a rate of 20% a year from year three to year seven. Meaning that if I quit after 6 years, I only get 80% of that 2.25% that my employer has matched. Note you are always fully vested in your own money. If I put 6% of my salary into a 401k and quit a month later, I get to take that 6% with me whereever I go.

IMNSHO, this is not the compelling reason for getting a 401k, however. The really good reason is taxes. If you make so little money that your income is not taxed anyway, a 401k probably isn't important to your financial planning.

Money put into a 401k is tax-deferred. That means you don't pay taxes on it until you withdraw it from the 401k.

Why is "tax-deferred" a Good Thing?

Let's say you make $20,000 a year, and you pay 15% in taxes. (You don't, but the math is easier this way.) If you don't have any income tax-deferred, you pay $3,000 a year in taxes.

Now, let's say you put 10% of your salary into a 401k, or $2,000. Now your taxable income is only $18,000. You pay $2700 in taxes, saving you $300 in your tax bill.

Yeah, but I still have to pay taxes on that $2000 when I withdraw it, so who cares?

Well, yes. But postponing that day is good in two ways.

First, as long as the money is tax-deferred, the interest, dividends, capital gains, etc. on it are tax-deferred, too. ("Capital gains" happen when you sell something for more than you bought it for. If you buy a share of stock at $10 and sell it at $15, your $5 profit is a "capital gain.") . Let's say that, instead of putting it into a 401k, you put your $2,000 in a money-market that pays 5% interest and you leave it there, accumulating interest, for ten years. At the end of the first year, $100 in interest will be paid on it, and the IRS will take their cut of $15 from that earned interest, and the remaining $85 will be added to your account. In the next year, you'll have $2085, it'll earn $104.25 in interest, the IRS will take their cut, lather, rinse repeat. After ten years, you'll have $3,032. You've been paying taxes on it all along, so you don't owe anything more on it--you can take it out and spend it all freely now.

Now, let's say you take the same amount of money and put it into a 401k. First, since you haven't paid taxes on it yet, you start with $2352. (Aren't takes a bite?) After ten years, you have $3,831 in the account. But, now you want to spend it, so the IRS comes for you and takes their 15% (bummer). But even after you pay the taxes, you still have $3,256 left over, or $224 more than if you'd been paying taxes on it all along.

The second reason tax-deferred is good is that, in the real USA, we don't all pay a 15% income tax -- and most people plan to have smaller incomes when they're retired. A smaller income means a lower tax bracket, and the money you withdraw from your 401k will be taxed at your income level now, not at the time you squirrelled it away. So if, say, you were making $60,000 a year before you retired, and in the 30% tax bracket, but now that you're retired, you're down to the 15% bracket. Now, instead of paying 30% a year on the aforementioned $2352, you only have to pay 15% at withdrawal. (In this scenario, you save almost $1500. Whee!)

What about getting the money back? Don't I have to wait until I'm 65?

Well, 59.5, actually, not 65. And the answer is 'yes and no.' There are rules for withdrawing 401k money prior to age 59.5 if you retire sooner--you can get a kind of pro-rated-over-your-lifetime amount when you're younger.

More importantly, there are two ways to tap your money early:

1) Buying your first house. A 401k is a good way to save money for your downpayment if you intend to buy a home and don't own one currently. I'm pretty sure you don't have to pay a penalty in this case, though you do have to pay the taxes on it that were deferred,

2) Hardship: Let's say you just quit your job and you need the money to pay the rent. You can tap your 401k by filing for a hardship. That means you won't be able to put any more money into retirement plans for 6 months. You will have to pay income tax on the money, and you may also have to pay a 10% penalty. But that's not necessarily so bad. If you can wait until a new tax year to tap your 401k, and you were in a 15% tax bracket the year before, but since you don't have any income this year except $5,000 you take from your 401k, you're not paying any taxes at all this year--so the 10% early-withdrawal penalty is still a pretty good deal. (I'm not sure about the 10% penalty. Congrass changes the rules on these things periodically and I haven't kept track, since I don't want to tap my 401k anyway. When Lut tapped his 401k last year, after several months of unemployment, I told him he didn't have to pay a penalty, and he didn't, and no one has since told us we were wrong.)

Anyway, I think that about covers the basics of a 401k. Next time, I'll talk about IRAs, which are more fun that 401ks anyway. (I should've started with them. Ah well.)

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