The journey for financial freedom and early retirement, particularly for people just starting out, begins with the powerful 401k. Since I started working after college, I have been fortunate enough to have access to a 401k through my work. So far, it has been my primary wealth-building tool and is one of my largest financial assets.
What is a 401k?
The 401k is an investment account, similar to any regular investment account, that comes with a few additional special perks in exchange for a few concessions. Before we get into the perks, I have some bad news. Unfortunately, the 401k isn’t available to everyone. Another term for the 401k is an “employer-sponsored retirement account”. The key phrase here is “employer-sponsored”, meaning in order to get a 401k, your employer has to offer one to you. Your company works as the plan sponsor, doing everything from picking the investment company, choosing investment options, making contributions directly from your paycheck, and negotiating fees. Because this can be a lot of work for companies, particularly smaller companies, not every company offers a 401k option. The silver lining, however, is that a pretty sizeable 79% of Americans work at places that sponsor a 401k-style plan.
Why is a 401k important?
The 401k has grown to be the primary retirement savings vehicle for most of the US population because of the many perks that come with investing in one. These perks span financial aspects (tax reductions and potential contribution matching) as well as psychological (paying yourself first), all of which add up to significant FIRE power for your early retirement.
For demonstration purposes, I’m going to compare Sally, who uses a 401k, and Ben, who passes up on the 401k to invest in a regular investment account. Both Sally and Ben make $100,000 and are in the 20% tax bracket. When they retire, they only need $60,000 per year, and are in the 15% tax bracket. They invest in index funds, and can expect to make 8% per year on their investments.
Income tax planning: One of the first and most immediate benefits is in “delaying” of income taxes, meaning that whatever you invest now, you don’t need to pay income taxes on. I want to emphasize “delaying” because the 401k doesn’t prevent you from ever having to pay income taxes, it just allows you to delay paying those taxes until you actually need the money in retirement. If you happen to find yourself in a lower tax bracket in retirement than the one you were in during your working years (as most people do), this can be a major benefit in the amount of taxes you pay over your lifetime.
Sally and Ben both save 10% of their salary for retirement, Sally in the 401k and Ben in a taxable investment account. Ben’s take-home salary is $80,000 after taxes, and he invests 10% of that, so $8,000. Sally invests in her 401k pre-tax, meaning she saves 10% of her $100,000, or $10,000. Already, Sally is starting with a higher investment balance than Ben is.
Company Matching: Some companies go beyond just offering a 401k and offer matching contributions as well. This means for every dollar you put into your 401k, the company will also put in some amount of money (up to a point). The two different companies I’ve worked at were very different from each other in how “generous” they were with their contributions. My current company only matches 25% of what I put into my account, and only up to 1.5%. This means I have to put 6% of my salary into my 401k to get an additional 1.5%. Meanwhile, my last company put in 2% no matter how much I put in, plus a 1-to-1 match up to 6%. This meant that if I put in 6% of my salary, they would add an additional 8%! In either situation, this is FREE MONEY and should never be passed up.
Sally’s company offers her a 1-to-1 match of her contributions up to 5% of her salary. Because she puts in 10%, or $10,000, her company will match her first $5,000 of contributions. Therefore, her starting investment balance goes from $10,000 to $15,000. Meanwhile, Ben doesn’t get a match because he decided not to use his 401k. The company doesn’t give him anything, and he still has $8,000.
Capital Gains Tax Exemption: While the 401k only delays income taxes you have it pay, it does exempt you from having to pay dividend and capital gains taxes on your investments. Over time, this can add up to a significant difference in your savings. Most people must pay a 15% capital gains tax on whatever it is they made on their investments. So, if a $10,000 investment grows by $1,000, you would have to pay 15%, or $150 to the government. A 401k lets you skip that tax payment entirely.
After Sally invests her $15,000 at 8% for 30 years, her account has grown to $151,000, netting her a gain of $136,000. Because she invested her money in a 401k, she doesn’t have to pay any capital gains on the $136,000. Meanwhile, Ben’s investment of $8,000 at 8% for 30 years grew to $80,500, a gain of $72,500. Because his investments are taxable, he must pay 15% capital gains tax of $10,875 to the government, reducing his overall investment of $69,625.
At this point, the difference in Ben and Sally’s retirements savings is striking. Ben’s investment account is just shy of $70,000, while Sally’s is more than double at $151,000. Sally still must pay income tax as she takes money out of her account, however it is at the lower rate of 15%, leaving her with an after-tax balance is $128,300. This is still 85% MORE money than Ben has at the same point in his life, even though they were making the same amount of money. Additionally, this difference is based only on 1 year of working! The dollar difference grows much larger when you factor in multiple years of working and saving.
I’ve turbocharged my retirement savings with my 401k. What am I giving up to get these amazing benefits?
Nothing in life is free, and the same goes for your 401k. In exchange for the benefits to your retirement savings, the government and your company ask a few things from you in return.
Vesting: Vesting is a tool companies use to hold on to their contributions until you’ve worked long enough at the company to “earn” them. How does it work? The investment company has 2 separate accounts for you, one with contributions you made and one with matching funds the company gave you. After a period of time (in my personal experience, about 2 years), the administrator takes money from your company contribution account and puts it into your own, or vested, account. Companies like this because if you leave before your contributions vest, they are able to take their contributions back. One important thing to note is that vesting only applies to the money that the company put in, not what you put in from your own paycheck. What you put in is yours, no matter how long you’ve been at your company.
Investment Options: Unlike other accounts, like taxable or IRAs, 401k’s often have a limited selection of investments you can chose from. In a 401k, you can’t speculate all your retirement savings on a few penny stocks, for example. Typically, your investment options are mutual funds that invest in many stocks across asset classes, size and geography to diversify your risk while growing your assets. For some people, this doesn’t matter much and doesn’t differ from what you might invest in otherwise. My 401k options consist of Vanguard index funds which would be my first choice anyway. However, some plans only offer funds with high fees. In a later post, I’ll talk about how to get out of situations like that using IRAs.
Liquidity: One of the costliest mistakes you can make with a 401k is taking money out of it too early. The official retirement age, the age at which you can take money out of your account penalty free, is 59 ½. At this point, you have access to your funds free and clear with no penalties. However, if you need your money to buy a house or even to retire earlier than 59 ½, you may have to pay the government a lot of money in taxes and fees. Withdrawing money from a 401k early means not only paying income taxes on your withdrawals, but also paying a 10% penalty on the amount you withdrew. This could mean a serious amount of money that negates all earlier benefits you got from investing in the 401k to begin with.
Investment Limits: The tax benefits of a 401k can be substantial. To protect the 401k from just being a tax-evasion tool for the ultra-wealthy, the government has put caps on how much money any one person can contribute to their 401k. In 2017, that cap is $18,000 per person (the cap grows a little bit almost every year, and is raised by $5,000 when you hit age 50). This is still a very sizeable amount. Contributing $18,000 per year for 30 years would leave you with a 401k balance of about $2M. A couple working together and savings $36,000 per year (like Mrs. NFF and I do) could reach $1M is just 15 years, and $2M in 22 years.
Despite these limitations, the 401k has become one of the best tools for people to build their nest egg and reach financial independence. The tax savings can add to real additional value, and the inability to trade frequently protects us from making poor investment decisions during periods of high market volatility. For any working professional looking to invest their money, the 401k should be the first stop. It may just be the best thing you can do to build lasting financial wealth.