In an earlier post, WTF is a 401(k) I spent a lot of time … ranting about pensions, and explaining why a 401(k) system is better. I didn’t, however, spend a lot of time explaining what a 401(k) actually is. So today I’d like to explain a bit about the different options for retirement accounts and what’s better in a few financial situations.
401(k)
Today’s standard for corporations is to offer employees a 401(k) match. What does this mean? Well it means that for every dollar you put into your own retirement savings, your company will match your donation. They might give a 1:1 match or a percentage. For example, a company may say they’ll match half of every dollar you put in up to 4% of your gross salary. In this example, if you put in 4% of your gross salary, your employer will give you an additional 2% for free, so you’ll be saving a total of 6% of your total salary. The additional 2% is free. No catch. So why would anyone not choose to do this? Well first of all, you have to be able to afford to save the 4% upfront, because once money is in a retirement account you typically can’t use it until you’re at the ever increasing retirement age, currently 59 ½. Yes, you have one more half birthday in your life to look forward to. Secondly, employees may have multiple options and don’t know which one to choose. Let’s look at some of those options in more detail.
A traditional 401(k) has to be offered through an employer, and therefore isn’t available for an individual on their own. Money is put into a 401(k) before you’ve paid tax on it, so you don’t pay the taxes on any gains or losses until you pull the money out. Your portion of the contribution is deducted from your taxable income for the year of the contribution. However, there is a contribution limit on the amount you can deduct for tax purposes, which varies based on the tax law in any given year. For 2020, you can deduct up to $19,500 for contributions across all qualified retirement accounts, which includes your 401(k)’s and Roth IRA’s (see below for details on Roth IRA’s). Corporations typically utilize a financial institution to provide your 401(k), so once you set it up the money comes directly out of your paycheck and goes into your 401(k) account. You can’t pull money out of your 401(k) until you reach the retirement age, unless you want to pay a significant 10% fee to the government, known as the early withdrawal penalty. There are certain exceptions to this penalty, listed by the IRS here.
Once the funds are in your account, you are responsible for choosing what to invest them in. The 401(k) institution typically provides a limited list of mutual funds for you to choose from which are balanced based on your various retirement needs. You should be able to gain assistance from the institution providing the 401(k), or you can hire an external financial advisor, (or mooch free services off your best friend like I do). For the most part, 401(k) investments are ones where you can “set it and forget it,” meaning that once you take the initial time to set it up, you don’t need to be actively trading. The typical advice is to re-evaluate your 401(k) investments annually. Some people find it a bit daunting to be in charge of their own investments in a 401(k), but my other article included a detailed rant on why it’s better for the employee to get the money upfront.
Most importantly, when you leave a job the money invested in the 401(k) is yours to keep. You can leave it in the previous company’s financial institution as a 401(k), but if you change jobs a lot this can make things complicated having money in many different institutions. My advice is when you leave a job, to roll-over the funds into an Individual Retirement Account “IRA”. In order to make sure you don’t accidentally trigger the early withdrawal penalty, it’s best to have one financial institution send the money directly to the new one. When I changed jobs last year and went through this process, I discovered with horror that this archaic process actually withdrew all the money out of one account, then they mailed a physical check to the new financial institution.
Individual Retirement Account
An IRA is the most basic version of a retirement account. Your employer might offer an IRA, or you can get one through your personal bank. Similar to a 401(k), contributions to a traditional IRA are pre-tax, with taxes paid on gains and losses at the time of withdrawal, and there are contribution limits set by the IRS each year. As previously discussed, IRA’s are also a useful tool to consolidate 401(k)’s from many different jobs. There is one interesting exception to the early withdrawal penalty for IRA’s, which is “If you qualify as a first-time home buyer, you can withdraw up to $10,000 from your IRA to use as a down payment (or to help build a home) without having to pay the 10% early withdrawal penalty. However, you’ll still have to pay regular income tax on the withdrawal”. Source
Roth Individual Retirement Account
As opposed to a traditional IRA or 401(k), a Roth IRA is an investment vehicle that allows you to invest money after you’ve paid taxes on it, and you don’t pay any taxes on the gains and losses in that account. There are still contribution limits and an early withdrawal penalty.
This decision comes down to whether you think you’re taxable income will be higher at the time of retirement, or not. If you’re early in your career, it may be beneficial to focus your investment efforts on funding a Roth, after maximizing any matching offered by your company. While your company may offer access to a Roth, contributions to one typically aren’t matched.
If you work for a corporation
First and foremost, put in as much as you can afford to take full advantage of any matching options. It is free money.
If you’re self-employed, side hustling, or a member of the gig economy
You won’t have access to employer-offered programs or matches, but that doesn’t mean you shouldn’t still save for retirement. The easiest option for anyone is to open an IRA or a Roth IRA.
For other options, there’s a few differences between if you qualify as self-employed, vs a contractor.
The self-employed can set-up what’s called a Simplified Employee Pension or SEP-IRA, which may allow you to contribute more than a traditional IRA. The downside is if you have employees you have to contribute the same amount for all employees (including yourself), even if they leave during the year.
If you’re self-employed with employees, you can open a Simple IRA. This will allow you to provide matching options for your employees. Similarly you can open a Self Employed 401(k), which may provide some extra benefits. However, any 401(k) plan must be managed by a financial institution, so there are additional fees and paperwork.
Source: How gig economy workers can save for retirement
If you work for the government.
If you work for the government or are in the military, this information might not apply. Many government employees still receive pensions instead of 401(k) options. I highly encourage you to save retirement funds in addition to your pension, and to find out why you can read my full rant on pension programs here.
As always, talk to a financial advisor for any questions on your particular financial situation.
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