What is a 401K? Would it be better to just invest in a regular brokerage account? I’ve heard both of these questions from countless people who feel a little overwhelmed about getting started. They have read my post on How To Start Investing, and want to get started, but they still aren’t sure what the benefit of a 401K really is.

Maybe you’re just entering the workforce or maybe you have been there for a while, but you’ve been reading and decided you need to get your retirement plan together. Either way, the 401K will probably be the starting point for many investors. For some people, a 401K is all that they will ever need!

The truth is that getting started can often be scary. The absolute best thing that you can do for yourself to get over this fear is to just start! Don’t be so afraid of getting off on the wrong foot that you don’t ever  start. Putting something away in the wrong place is almost always better than not putting anything away. The sooner you start, the better off you’ll be! In order to boost your confidence and help you overcome your fears, we’ll give you the basics on what will likely be your first steps towards retirement.

What is a 401K?

A 401K is a type of retirement account that you may have access to through your employer. When you contribute to a 401K, your employer takes your contribution out of your paycheck before you pay taxes and then invests it through a plan provider. Once your money is with the provider, you usually have different mutual fund options to invest your money in. In a 401K your money will grow tax free until you hit retirement age. At that point in time, you will start withdrawing your money and will then pay taxes at that time.

Some 401K plans allow you to pick and choose individual stocks, but for most beginner’s you shouldn’t be picking individual stocks just yet. You have to learn to crawl first after all. There is also a lot of evidence that shows that most people just suck at picking stocks, so invest in a mutual fund and leave it to the pros or an index formula.

How Does A 401K Benefit You?

There are two major benefits of using a 401K.

1. You are lowering your tax bill today by contributing to a 401K. This works because the money is taken out of your paycheck BEFORE you pay taxes. To the tax man, it looks like you are actually making less money, so he takes less from you today
2. Your investments get to grow tax free! Many mutual funds and stocks give out money to shareholders periodically (this is called a dividend), or if you own bonds they are called interest payments. In a regular taxable account, you will be taxed on this income as you earn it. It may not seem like much, but getting these dividends/interest payments tax free and reinvesting them has dramatic effects on your balance over time

401K vs Taxable Account Over Time

For this comparison, we will make a few assumptions.

1. You have no assets on your 30th Birthday
2. You start investing when you turn 30
3. You are in the 15% tax bracket
4. You contribute $1,500 each month pre-tax or you contribute $1,500 – 15% for taxes = $1,275 each month in a taxable account
5. Your annual return is 7% (5% capital gains and 2% in dividends) with monthly compounding

Based on the assumptions above, by the time you hit your 65th birthday we will see some dramatic differences. The taxable account will have $2,138,676.55, but the 401K account will have $2,701,581.90. That’s a difference of $562,905.35 for simply choosing a different account to put your money in! Make sure you start taking advantage of these accounts today!

Don’t forget, this completely ignores any matching benefits that you may get from your employer for using a 401K. Let’s assume you make $60,000 and your employer will match up to 3% of your contributions. This is an additional $150 added to your 401K each month by your employer. Let’s see how this adds up.

That additional $150 each month from your employer adds $270,158.19 to your 401K account by the end for a grand total of $2,971,740.09.That’s also $833,063.54 more than the standard taxable account. Not a bad nest egg, and let’s face it, you can probably retire years earlier than age 65 at this rate!

401K Rules

This awesome retirement vehicle does come with a few rules. As long as you play by the rules, then the 401K is an excellent way for you to increase your retirement savings without doing anything special.

1. At the time of this writing, you can only contribute up to $18,000 per year if you are under the age of 50. If you are 50 or wiser, then you can contribute an additional $6,000 per year in catch-up contributions for a total of $24,000 per year.
2. Your employer can contribute to your 401K is entirely up to them, but they can contribute up to a combined $53,000 with your contributions. That means if you contribute the maximum of $18,000, then your employer could technically contribute up to $35,000 to your 401K.
3. You can’t pull money out of your 401K until you reach an age of 59 1/2. If you do, you will both have to pay taxes at that time and you will be hit with a penalty for withdrawing early. However, there are advanced strategies out there for withdrawing sooner without penalty for early retirees. The Mad Fientist has some great articles with numbers behind these strategies.

Keep in mind that although there are limits on how much you can contribute, that doesn’t mean that you shouldn’t contribute more if you can! The more you put away today, the sooner you can retire! Just make sure to max out that 401K first if you can!

How Much Does It Cost?

Like everything else, there is a small cost associated with owning investments. These are called fees and pay the people who administer the fund and deal with all the legal stuff. They have to keep the lights on too after all. That being said, it is in your best interest to select a fund with extremely low fees because you are sharing that expense with millions of other people so it shouldn’t cost you very much.

When choosing your fund, be sure to take a look at what the fees are. If you’re paying over 1% in fees, then choose a new fund. For example, one of my favorites, the Vanguard Total Stock Market Index Fund Admiral Shares has an expense ratio of just 0.05% (I do not earn a penny for suggesting Vanguard. I am just a big fan)! John Bogle, the founder of Vanguard, consistently warns about how high fees in mutual funds can really screw you over. Here is a great article about how fees easily wipe out more than 63% for your money.

Warnings

1. Do NOT withdraw early and get hit with penalties. This is a terrible financial mistake. You might as well light your cash on fire in your back yard. Just DON’T DO IT
2. Do NOT take out a loan against your 401K. Yes, you can technically do this, but DON’T do it! No matter what some real estate agent tells you, don’t do it. One of the benefits is the tax free growth, but if you pull your money out, then it’s not invested and growing! Yes, you are paying the loan back to yourself instead of a bank, but DON’T do it! Even if you are still tempted, be warned that if you leave your job before you paid the loan back, then you will get hit with penalties.

What If You Don’t Have Access to a 401K?

Some people don’t have access to a 401K. In the non-profit sector, a similar account is the 403B. If you do not have access to either one, then look into a Traditional IRA. These accounts have similar features and provide you with the same pre-tax and tax-free growth benefits of the 401K, but may have different contribution limits and particular rules. For example, the Traditional IRA has a contribution limit of $5,500 per year at this point in time. The important part as we learned earlier, is that you are getting the tax free growth and the tax benefit today of lowering your earned income.

Important Note: You can contribute to both a 401K/403B and an IRA. If you have the funds to do so, you can and should max out both your 401K/403B and your IRA!

Start Using A 401K Today!

The 401K is an incredible tool that you can use to boost your retirement savings throughout your life. Find out from your employer today if they have a plan and if they have a contribution match. There is no time to lose, and your future self will thank you.

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