401(k) Contribution Plan
Gabe Fransen | July 26, 2022
In the late 1970’s Congress enacted Internal Revenue Code Section 401(k) as part of the Revenue Act, which set the path for employees to contribute a percentage of their salary to their employer’s 401(k) plan. There have been several detailed changes to 401(k)’s since then, but the basic concept has remained the same – tax deferred retirement savings with the option of an employer match. Starting in the 2006 tax year, employees have been allowed to contribute to a Roth 401(k) where employees were allowed to make after-tax contributions for tax free accumulation and tax free distributions.
We often hear from folks that have recently entered the workforce and are a bit confused about their 401(k). Typically they get hired by a new employer, the employer or HR sits them down, gives them some packets, or maybe they are just emailed some information about their 401(k) plan and they don’t really know what they are looking at. They’re probably not really even paying attention as they are trying to get used to their new workplace, their new coworkers, where to get lunch, etc…. All of a sudden, they have a new 401(k) account set up and they’re not really sure what is going on.
We try to put the cookies on the lower shelf and not confuse them even more. Look at a 401(k) as a storage shed or pole barn where you store your belongings. Maybe in your shed or pole barn you have garden tools or a boat or a classic car, etc. Inside the 401(k), instead of having those physical assets being stored, you are storing stocks, bonds, mutual funds, etc. So different types of investments go into your 401(k), so the actual 401(k) isn’t really worth anything on its own, however the value is in the assets.
The 401(k) is a type of retirement account that the government provides to help us prepare for retirement because they know that Social Security is a supplement for retirement income for most and the government wants us to be financially independent in retirement to reduce the potential for hardship cases that may require additional government funds to care for those situations. So the 401(k) is the retirement account that most people who work for somebody else have access to.
The basic concept of a 401(k) is that you are pushing off the immediate tax burden of the invested amount of your income and instead you’ll be taking the tax hit when you take distributions from your 401(k) in the future. So the more that you are able to put away in your 401(k), the more short term tax benefits you’ll have all while using the time value of money to have tax deferred growth on your assets. The whole purpose of the 401(k) is to help you prepare for retirement, so to discourage investors from taking distributions prior to retirement, the government requires you to wait until you are 59 1/2 before taking distributions from these accounts. If you take distributions prior to turning 59 1/2, they will slap a 10% fee on you in addition to the regular income tax for the distribution unless you qualify for one of the few exemptions.
Some companies allow for an in-service rollover, which allows employees to transfer the assets from the current employer 401(k) plan to an IRA. Besides the in-service rollover, for the most part, your 401(k) can’t be moved while you remain employed by the company who’s providing the 401(k) plan. However, once you are no longer employed by that company there are often times a few things you can do with your 401(k):
Oftentimes employers will offer to match your contribution up to a certain percentage of your income. An amount that we often see is 3%, which means if you are willing to contribute 3% of your salary to your 401(k), the employer will contribute that same amount as well. However, if they are matching up to 3% and you contribute 6%, they will only contribute the 3% of your salary amount to your 401(k). Now in some cases, they might only match a certain percentage of your match up to a certain percentage. For example, it could be a 50% match up to 10%, this would mean on a $100,000 salary, you could contribute $10,000 and they would contribute $5,000.
Generally speaking we encourage investors to contribute to their 401(k) up to the point where the employer no longer matches. If you think about it, whatever the match your employer is providing, that is an automatic return on your investment. If we once again use the $100,000 salary for an example and let’s say the employer matched 100% up to 3% salary contribution. You are contributing $3,000 annually and with the employer contribution the same amount, without doing anything, you have gotten a 100% return on your investment and is now $6,000. Even at a 50% match from the employer, your $3,000 turns into $4,500 and you’ve gotten a 50% return on your investment. If you can put professional money management with active allocation of those investments on top of that 50% or 100% match, you can see how valuable of an investment tool the 401(k) could be if handled correctly.
There are annual contribution limits that are in place for the 401(k) plans. At the time of this writing, the annual contribution limits for 2022 are $20,500. However, for those that are 50-plus years old, the government has provided the ability to “catch-up” on your retirement savings and allow annual contributions of $27,000, which is a $6,500 additional contribution annually.
One of the things we caution our clients that have a 401(k) is to be aware of how they are invested. Many times, by default, the 401(k) adviser selects what is called a Target Date Fund. In the 401(k) investment menu, there are often several funds that are called Target Date Funds. We typically see that there is a target date fund for every 5 years, so it could look something like this:
These funds are essentially managed based on the expected retirement date of the investor. So instead of investments being managed based on the individual and their goals, the investments are being managed based on an expected retirement date. With these funds, we often see that they carry a high expense ratio. Expense ratio is basically a measurement of how much is paid to be in the fund, the higher the expense ratio, the more the investor is paying. If the fund has a 1% expense ratio, and the fund grows by 2%, half of the earnings would be going back to the fund.
With the 401(k) often being the majority of the retirement assets for individuals, we believe that it is crucial to optimize the 401(k) by maximizing return potential, limit downside risk and reduce expenses in the 401(k) allocations to have the best shot of living the type of lifestyle in retirement that is desired.
For additional information on how active management can supercharge a 401(k) account, check out the 401(k) Maneuver website: https://www.401kmaneuver.com/
For a calculation to the potential benefit on 401(k) account, this is a pretty simple calculator to use: https://www.401kmaneuver.com/401k-calculator/
In addition to a well managed 401(k), proper retirement planning can determine the amount that should be contributed to the company sponsored 401(k) and what other savings/investing strategies to implement in order to give you the best shot at having the desired retirement lifestyle.