Retirement Planning Basics: the 401(k)

Austin has long been an oasis for entrepreneurs, with fertile soil to plant ideas and an ideal climate for innovation. In recent years more and more companies are recognizing this and are migrating to central Texas to join our entrepreneurial ecosystem. As Austin becomes home to more and more emerging companies, top talent is also moving to Hill Country for their employers. 

While many of these talented people are seasoned professionals, some of them are more green and new to the world of robust employee benefits. They come equipped with a lot of knowledge about their field and less prepared to navigate the nuances of things like healthcare and retirement plans.

Keeping these young Austinites in mind, we are initiating a series addressing retirement plans for the novices and newbies new to the 512.

To kick us off, we’ll give you the 411 on 401ks.

What is a 401(k)? 

A 401k is an employer sponsored retirement account with a dedicated contribution plan that gives employees the opportunity to invest in their retirement with certain tax benefits. It’s named after the 401k tax code that defines and established this type of plan. Many financial advisors and professionals consider the 401k as the main investment vehicle for retirement. 

Before 401ks were created, most employees relied on a pension for their retirement planning, which is an amount that their employer committed to distributing to them during their retirement. Now, pensions are far less common, and most people utilize 401ks for their retirement planning, among other strategies. 

Employees can dedicate a portion of their earnings to the plan which invests their money in a variety of vehicles such as stocks, bonds, and mutual funds. Employees select investments from what their employer offers, which often includes the employer’s own stock and Guaranteed Investment Contracts as well as more general investments. 

The benefits of a 401k and how much money they can reap for an individual depend on which type of 401k you have, how your employer structures it, and standardized rules enforced by the IRS.

Traditional vs. Roth

There are two main types of 401(k) plans – a traditional 401k and a Roth 401k. The difference in these plans is how they are taxed.

With a traditional 401k, employees allocate a portion of their paycheck to the account and that money is not taxed. This means that it reduces the employee’s taxable income for the year. However, the tax man always comes around eventually, and when you ultimately withdraw this money for retirement, the contributions and earnings will be taxed. 

Even so, having their 401k contributions as a deduction on their gross income is helpful for many employees. This can even put some individuals in a lower tax bracket for the year, meaning they will owe less as a result of saving a portion of their money for later use. The fact that these savings grow tax-deferred means that your money grows faster while it sits in the account. 

Contributions to a Roth 401k, on the other hand, are deducted from after-tax income, meaning any money contributed has already been taxed for income taxes. This does not give the employee a deduction in the year of the contribution but it does mean that when the money is withdrawn for retirement there are no additional taxes due on the initial contributions or their earnings. 

If your employer offers both types, you are welcome to contribute to both a traditional 401k and Roth 401k. To optimize your retirement accounts, it’s best to consult a professional financial advisor for their advice and expertise.

Employer Matching 

The tax breaks are great and all, but another great quality of 401k plans is that employers sometimes match their employees’ contributions. Some consider it free money, and we won’t deny that the employer match is a nice, self-selective bonus. Many employers consider it an employee retention benefit. The details depend on your employer, but some will match contributions dollar-for-dollar while others will match less – fifty cents for every dollar, for example. 

There is usually a maximum amount that employer matching is applicable to, and most financial advisors consider it best practice to contribute this amount, or as close to it as the employee can manage, considering that maximum contributions will help accumulate as much earnings as possible in the shortest time frame. As you can imagine, contributions and employer matching adds up over time, and your 401k will be sitting pretty for the day you retire. 

IRS-Imposed Limits

The maximum amounts that employees and employers can contribute to 401k accounts are adjusted each year for inflation. For 2021, the cap is $19,500 per year for workers younger than 50, and in 2022 this figure will be $20500 per year. Workers 50+ years have slightly higher 401k contribution maximums in case they want to maximize their retirement savings. 

Employer matching brings this maximum up a good amount, with the limit being $58000 per year in 2021 and $61000 per year in 2022 for people younger than 50, or 100% of compensation – whichever is lower. This is also slightly higher for workers over 50 – those maximums are $64500 for 2021 and $67500 in 2022.

If You Move On Before Retirement

Many financial advisors consider it best practices to roll over your 401k if you change jobs. A 401k rollover describes a transfer of funds from your employer sponsored retirement account to an individual retirement account (IRA account) or to a 401k with your new employer. 

It is best to employ the help of a financial advisor in this situation as they are familiar with the strict rules the IRS has put in place around retirement accounts and will be able to help you maximize your earnings and avoid expensive mistakes. 

A 401k rollover into an IRA at a brokerage firm, bank, or mutual fund company will enable you to choose from a wider range of investment choices and will also avoid immediate taxes. 

Moving the 401k to a new employer can be a good option for those who are less savvy with investing and are not comfortable making the investment decisions triggered by a rollover IRA situation. This leaves all decisions in the hands of the new plan’s administrator and also avoids immediate taxes the same as in a rollover IRA. 

Leaving the 401k with your old employer is an option, if your employer has structured the program such that departed employees can leave their 401k indefinitely. You can not make any further contributions in this instance and this option  generally only applies to accounts in the amount of $5000 or greater. It can be a good option if the employer’s plan is well-managed and the employee is happy with the investment choices their plan offers, but this can also create a line of phantom 401k accounts that are hard to keep track of, which can be especially confusing for heirs. 

401k Withdrawals

401k owners must be at least 59.5 years old to withdraw from their accounts, or they will face the 10% withholding fee described above. Because it’s hard to withdraw from a 401k, many financial planners advise that you have an easily accessible emergency fund built elsewhere and have not put all your savings into the 401k. 

After 72 years old, all retired account owners must withdraw a percentage from their 401k accounts based on a life expectancy table outlined by the IRS. The rules are slightly different for those who are still working. 

If an employee expects to be in the lower tax bracket when they retire, a traditional 401k can be a great option, as they can take advantage of the immediate tax break while making contributions. Those who expect to be in a higher bracket might prefer a Roth so they avoid taxes on their savings later. If the Roth has years to grow, you will be able to withdraw all the earnings in your Roth 401k without being taxed when it is time to retire. The Roth reduces your immediate spending power but has benefits in the long-term. 

Of course, this is just an overview and not recommendations or advice – reaching out to a financial advisor who can learn about your specific situation will help you make the best decisions about your retirement planning options based on your current finances and your long term goals. 

There is a lot to consider in terms of your career and how it can play a role in your financial planning and goals personally and for your family. Reach out to us at info@nestfinancial.net to maximize your retirement planning options and create a financial plan that gives you freedom and confidence, both now and in your golden years of retirement. 

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DISCLAIMER: We are legally obligated to remind you that the information and opinions shared in this article are for educational purposes only and are not financial planning or investment advice. For guidance about your unique goals, drop us a line at info@nestfinancial.net.