Some terms are so commonplace that it is assumed that everyone knows that it is supposed to mean. A 401k refers to a plan that has to follow specific criteria in order to allow employees to stash away some money that is excluded from their taxable income calculation. Just like health insurance plan, dental insurance plan, disability insurance and life insurance plan a 401k is a benefit plan that is offered by an employer to entice you to work for them.
401k money isn’t taxed initially and it lowers your taxes
The key point of a 401k is that it allows you to put money away that isn’t taxed initially. To illustrate this point picture your paycheck that you just had deposited in your account by your employer. We are going to assume you are a salaried employee and receive a W2 paycheck which means taxes have already been taken out. So the $8,000 that got deposited already had federal income taxes taken out along with states income taxes and payroll taxes. You were already taxed at somewhere in the 45% range before even being able to do anything with your paycheck. If you took $1,000 from this $8k and put it in a savings account you saved 12.5% of your paycheck ($1,000/$8,000*100).
But, your pay (not paycheck, so the gross income) was closer to $14,000 right? Now, imagine you took $1,000 from your paycheck before it got taxed. You would still get that $1,000 to stash away AND you lowered your taxes because instead of getting taxed on $14,000 you are only taxed on $13,000.
Your 401k gets taxed at your income-tax-rate once you take it out in retirement
I know that was lengthy and convoluted but I hope the point comes across. Yes, your paycheck will be a little lower because you took money out of it but fuck, it’s not like you spent that money on popsicles. My main point is that the $1,000 you put away in a 401k has a higher value than the $1,000 you would take out of your after-tax paycheck.
You can invest that $1,000 and allow to grow tax-free. Once you take this money out of your 401k account (let’s say when you are 65) you would need to pay taxes on it but until then any dividends or appreciation that it benefits from is non-taxable. True, taxes may be high by the time you take this money out but they may be lower so it’s a toss-up (some predict taxes will go up in the future, others predict it won’t change by much). Even if taxes are higher, the rates would be “income tax rates” and not “investment taxes” so the good old USA will likely give the poor a break. Which means if you aren’t taking out too much then you aren’t going to be taxed as high.
There are different types of 401k accounts
A 401k has to be offered by your employer. If you are a part-time provider and your company doesn’t offer it then you can’t have a traditional 401k account. There are other types of 401k plans that I won’t get into here.
A 401k plan needs to be managed by some financial institution. That’s where those names like Fidelity, Charles Schwab or Vanguard come in. When you deposit your pre-tax $1,000 in your 401k it will be held, for example, at Charles Schwab. There, you have some investment options. Naturally, CS will give you some of their own in-house investments that will suck ass because of high fees. They will also offer you a few popular low-fee investments (generally Vanguard). Which will perform better? I have no idea, the “word” on the internet is that Vanguard is the shit. Yes, you can look at their fund performance historically and decide but there is much more to it. This is where a good financial adviser will help out.
2015 401k limits are $18,000
So, you deposit your money with CS (Charles Schwab) and you watch your money grow or go down, depending on the market. You set up your account to automatically max out your IRS allowable max distribution every year. Currently it’s $18,000 per year and in a few years it will be much higher, I’m sure. Again, the nice thing is that you don’t pay any taxes on this. You can buy and sell within a 401k and even though there may be some trading fees, your $18k invested may grow to $25k and you wouldn’t have to pay any taxes on that $7,000 in capital gains. If you had that $18k invested in a private account at CS with after-tax money then you would have to pay taxes on that $7,000.
Now, a few years go by, you develop a gambling habit, a drinking habit, you get a divorce and you decide it’s time for a nose-job. No worries, you can still have access to that 401k even though you haven’t hit retirement age yet. Even though your liver is in its 6th decade your driver’s license says 40. In order to not pay a penalty tax you have to be at least 59.5 before withdrawing money from your 401k.
Taking your money out of your 401k... there are several ways
There are 2 methods to get at your money without paying any penalty taxes. At 40 years old you can still take money out but it’s a little bit of a hassle. You can take out what’s called Substantially Equal Periodic Payments (SEPP), also called a 72(t) distribution. With this method a certain percentage of your 401k every year is distributed out to you. To determine this percentage you have to look at some interest rate/tax tables every year. I won’t get into that here but through this method you gain access to your 401k before age 59.5. The downside is once you start it you can’t stop this, it will continue until you hit age 59.5.
The other method of accessing your 401k is by converting it over to a Roth IRA account and building what’s called a Roth conversion ladder. I found a great explanation here, here, here and here… oh and here… just fucking with you guys, they are all the same link. But, it’s a good one and worth reading. If you don’t wanna read it the gist of it is that you convert a portion of your 401k to a Roth IRA which creates income taxes. It takes 5 years before you can access the converted amount so you repeat that every year and so on. Ok, I fucked up the explanation, read that post!
So, there you have it. 401k… a good way to let your money grow tax-deferred and a good way to lower your income taxes. And now you hopefully have a good idea what a 401k is.
Should you invest in a 401k? That’s a whole other discussion. I don’t have an answer for that. It seems that for us high-income folk it’s a good way to decrease our tax burden. I have had some really good discussions with my financial adviser about this and for now I will continue to invest in my 401k.