Retirement Accounts Part 1: 401(k) Plans

In this blog post, I’ll share what I’ve learned so far about investing in retirement accounts. Though I heard the word investing several times throughout my life, I never thought that at some point I would become an investor. I thought investing was what rich people did with all the money they couldn’t spend. Through listening to podcasts and reading books on financial independence, I learned that I had the order wrong. Instead of spending whatever I had left, in order to amass wealth, I had to pay myself first. I got more comfortable with taking control of my retirement accounts (401(k)s, IRAs, HSAs) and optimize them as much as possible as I continued to research the topic with the financial independence mindset of long-term investing.

The least scary place to practice how to invest was my 401(k) account. Thankfully my employer provides a 401(k) so I couldn’t possibly mess it up too much-I thought. As I’ve written before I had no idea what I was doing when I set up that account but I clicked my way out successfully. There were a lot of terms I was not familiar with back then and I’m definitely still learning. Today I’ll break down what I’ve learned about investing in retirement accounts, specifically 401(k) plans. I’ll review Roth IRAs, Traditional IRAs in future posts in order to not make this one too long. I also utilize a Health Savings Accounts (HSAs) as a retirement vehicle which I’ll review in a future post.

I think an easy way to compare and understand the differences between these vehicles is to look at what your money will do going into the account (contribution), how your money grows (investment growth), and how easy it is to pull the money out of the account once you need it (drawdown). This will be by no means an all-encompassing review and your employer plan might have some additional nuances, so do your research before opening an account and make sure that it meets your needs.

Three Phases of Retirement Accounts

401(k) Contributions

First, let’s talk about the 401(k). This one of the most popular vehicles and many employers provide 401(k) plans where their employees can invest pre-tax dollars. One important distinction is that your contributions to a 401(k) will lower your taxable income. This is an incentive from the government for employees to save for retirement on their own as more businesses move away from the pension model. Increasing your 401(k) contributions can reduce the amount of tax you have to pay throughout the year. This is where the term pre-tax dollars come from, the dollars that you contribute to a 401(k) are not subject to income tax, and therefore reduce the amount of taxes you pay to the government. This is why 401(k) are considered tax-deferred vehicles, where you will not pay taxes on your contributions or dividends until you start pulling money out.

For the tax year 2020, the IRS contribution limit was $19,500 for a taxpayer filing single. Employees over 50 years old can also do catch up contributions up to $6,500. This gives a little bit of extra room for additional savings for those closer to retirement.

Another benefit of 401(k) plans is that your employer can provide a match to your contribution. For example, an employer could match employee contributions dollar for dollar up to 4%. Let’s say you made $1000 and you decide that you will contribute 6% ($60) to a 401(k) plan. Your employer will then “match” your contribution up to 4% ($40). This means that you will have the $60 you contributed plus $40 from your employer, for a total of $100 going into your retirement savings. This is essentially FREE MONEY, that your employer is paying to you, to incentivize saving for retirement. I’ll say it again, your employer is giving you FREE “CASH” MONEY, so if you would like to give yourself a free raise and “treat your future self”, it would be a good idea to look into your employer’s benefit plan and ensure that you are getting that match!

401(k) Investment Growth

Now that we’ve covered the advantages of contributing to a 401(k), let’s talk about the benefits of investing in a 401(k). As I mentioned earlier, the government wants employees to save for retirement. In order to make this even more appealing, any dividends are not taxed when deposited into your 401(k). Remember that dividends are what a company pays you for being a shareholder. 401(k)s are tax-deferred, which means that the tax will be paid later. Dollars contributed to a 401(k) go in tax-free, but you will pay taxes at your applicable tax rate when you start pulling money out of the account. Any dividend income generated within the vehicle will not be taxed until you start pulling money out of the account.

401(k) Drawdown

Finally, after so many years of being a 401(k) millionaire, the time has come to start drawing down on your nest egg. It is at this time that you will get taxed on your 401(k) income. Every dollar you receive will be taxed at the tax bracket you are when you pull the money out of your 401(k). If you are planning to be in a much higher tax bracket when you start drawing down your 401(k) you’ll need to plan for taxes! It’s also important to point out that similar to other retirement vehicles, you will be subject to penalties if you try to pull money out before you turn 59½.

In summary, 401(k) plans allow you to:

  • Save for retirement while lowering your taxable income by contributing pre-tax dollars up to the IRS contribution limit
  • Dividend income is not taxed until you pull money out of the account
  • Taxes will be due when you are pulling money out of the account

If you are looking to save more for retirement while paying fewer taxes, a 401(k) might be a great option. There is a good chance that your employer offers this plan, give your HR department a call to check! Investing in retirement accounts is definitely one of the levers we are pulling in order to reach financial independence, and it might be right for you too!

In Part 2 I’ll review what I’ve learned about Traditional IRAs and Roth IRAs. I’m currently in the process of deciding which vehicle will work best for my current situation. Should I try and pay fewer taxes now with a Traditional IRA? Or, should I go for the peace of mind that a Roth IRA offers by being able to pull out my contributions at any time? Stay tuned for an upcoming post! Thanks for reading!

*The content posted on this website does not constitute professional financial advice. Please consult a certified financial planner or investment advisor for professional financial advice*

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