What Is A 401 Everything You Need To Know
11 Minute Read | September 27, 2021
If you just started a new job and youre looking at the 401 options that are available, you probably have questions about how it all works.
You might be wondering: How do I know these are good investment options? How much should I invest? What kind of return should I expect? And what in the world does vesting mean?
If youre leaning on your 401 to be a big part of your financial picture, its important to get your questions answered. Your golden years literally depend on investment choices you make today. Learning how your 401 works is the first step toward making confident decisions about your retirement future.
Lets get started!
How Much Should I Have In My 401k
If youre wondering how much money you should have in your 401k, your wait is over. Retirement savings is much of the talk in todays personal finance world.
You want to make sure youre saving enough to meet your retirement goals. Otherwise, you may have to find ways to save more or possibly delay retiring.
While each person has a different financial situation, these insights can improve your retirement plan.
In This Article
Disadvantages Of Closing Your 401k
Whether you should cash out your 401k before turning 59 ½ is another story. The biggest disadvantage is the penalty the IRS applies on early withdrawals.
First, you must pay an immediate 10% penalty on the amount withdrawn. Later, you must include the amount withdrawn as income when you file taxes. Even further down the road, there is severe damage on the long-term earning potential of your 401k account.
So, lets say at age 40, you have $50,000 in your 401k and decide you want to cash out $25,000 of it. For starters, the 10% early withdrawal penalty of $2,500 means you only get $22,500.
Later, the $25,000 is added to your taxable income for that year. If you were single and making $75,000, you would be in the 22% tax bracket. Add $25,000 to that and now youre being taxed on $100,000 income, which means youre in the 24% tax bracket. That means youre paying an extra $6,000 in taxes.
So, youre net for early withdrawal is just $16,500. In other words, it cost you $8,500 to withdraw $25,000.
Beyond that, you reduced the earning potential of your 401k account by $25,000. Measured over 25 years, the cost to your bottom line would be around $100,000. That is an even bigger disadvantage.
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Consider Your Personal Circumstances
There are many factors you should consider when deciding when to start receiving your CPP retirement pension. These include your health, your financial situation, and your plans for retirement.
For example, if youre healthy, expect to live a long life, or have access to other sources of income, you may choose to start receiving your CPP retirement pension later. This will result in a larger monthly pension, which could help protect you from outliving your savings.
However, if youd prefer to work less, or you want the money now to pay off debts or to fund your retirement plans, you may choose to start receiving your pension before age 65. This will result in a smaller monthly payment which can help meet immediate needs, especially if you have little or no other income.
The Canadian Retirement Income Calculator can also help you better understand your future financial security.
Your Retirement Money Is Safe From Creditors
Did you know that money saved in a retirement account is safe from creditors? If you are sued by debt collectors or declare bankruptcy, your 401k and IRAs cannot be liquidated by creditors to satisfy bills you owe. If youre having problems managing your debt, its better to seek alternatives other than an early withdrawal, which will also come with a high penalty.
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Withdrawal Options If Youve Been Impacted By Covid
First off, you should know that you have some new options when it comes to taking money from your 401 if you have been negatively impacted by coronavirus. Generally speaking, these new options that arose from the CARES Act include the chance to withdraw money from your 401 without the normal 10% penalty, but you also get the chance to take out a 401 loan in a larger amount than usual.
Here are the specifics:
A Couple Of Things To Remember
You own the money you contribute to your 401 so if you change employers, you can roll it over into your new employers 401 or another qualifying retirement plan account.
Keep in mind that your 401 plan operates on the assumption that you are saving for retirement so once youve put dollars in, there are penalties if you decide to take them out before you reach retirement age.
To withdraw the money means you also miss out on the advantage of time and its effect on compound interest.
Saving early and increasing your contributions as you go can help set yourself up for a secure retirement.
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Best Places For Employee Benefits
SmartAssets interactive map highlights the counties across the country that are best for employee benefits. Zoom between states and the national map to see data points for each region, or look specifically at one of four factors driving our analysis: unemployment rate, percentage of residents contributing to retirement accounts, cost of living and percentage of the population with health insurance.
Investment Choices Can Be Limited
When you open an IRA, you’re generally given the choice to hand-pick stocks for your retirement portfolio. Doing so could help you grow a lot of wealth in your retirement plan, especially if you know how to research companies well.
With a 401, you generally can’t invest in individual stocks. That limits your choices and may create a situation where the options you’re presented with don’t align with your personal strategy or goals.
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How Many Types Of 401s Are There
There are two basic types of 401straditional and Roth. Both are employer-sponsored retirement savings plans, but theyre taxed in different ways.
A traditional 401 offers tax benefits on the front end. Your money goes in tax-free, but you pay taxes on the employer match and the withdrawals you take out in retirementthat includes all the growth on your contributions as well.
A Roth 401 offers tax-free growth. What does that mean? Your contributions are taxed up front with after-tax dollars, but then you dont pay taxes on your contributions or their growth when you retire. You will still owe taxes on employer contributions.
There are also a few other types of 401s available for folks who are self-employed or own small businesses:
- Solo 401: Also known as a one-participant 401, the solo 401 was created for business owners who work for themselves and dont have any employees. It allows you to make contributions as both an employee and as an employer.
- SIMPLE 401:If youre a small business owner with no more than 100 employees, then the SIMPLE 401 is for you . As an employer with this plan, you must offer a matching contribution of up to 3% of each employees pay or put in 2% of each employees pay .1
The Wealthy Dont Use Them
If you were stuck in an elevator with a wealthy person and got to ask them how they amassed their fortune, I guarantee they wont say it came from placing a small fraction of their paycheck into a 401k, allowing someone else to manage it, and waiting until retirement to touch it.
Wealthy people take a different path, which is to invest in income-producing investments throughout their lifespan. As financial guru Grant Cardone explains, wealth is acquired by increasing your income, investing in income-producing assets, and protecting as much of your income a possible.
Put simply, wealthy people rely on three strategies . These are:
As Tony Robbins wisely says, Success leaves clues. By this he means, you should model the people you want to be like. If youre aspiring to be financially free, then you would do well to observe how wealthy people act and use a similar approach to achieve financial freedom yourself.
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Why Examine The 401
Why am I writing about 401ks? The short answer is that it is a fascinating subject.
As we explore it, youre more than welcome to listen and learn or youre welcome to ignore my perspective. I have no agenda here, nor anything to sell.
I simply want to educate you about the facts, share some history, and explore the myths youve likely been told by the people around you. Then you can decide.
What may be noteworthy is that Ive been studying the tax code for decades, read books about this topic in my spare time, and regularly dig through the dreaded IRS tax code which is an estimated 74,608-pages long.
Thankfully, the online version of the tax code lets you search by topic. Phew!
However, if youre not keen to believe me, you can also listen to financial experts like Grant Cardone or James Altucher, who share my perspective that 401ks are a scam. In Grants words, The 401 is merely where you kiss your money away for 40 years hoping it grows up.
As James puts it, are scams. This is another trillion dollar industry that has a lot of money at stake if people stop believing in the mythology bolted to the scam Then there is revenue-sharing between employers and 401k plan managers. Is this legal? Yes.
What created financial freedom for me was not money within a 401k that I cant access for decades.
It was cash flow from assets and investments that pay me today. With that context, should we get started?
Option : Roll Over Your Old 401 Into An Individual Retirement Account
Still another option is to roll over your old 401 into an IRA. The primary benefit of an IRA rollover is having access to a wider range of investment options, since youll be in control of your retirement savings rather than a participant in an employers plan. Depending on what you invest in, a rollover can also save you money from management and administrative fees, costs that can eat into investment returns over time. If you decide to rollover an old 401 into an IRA, you will have several options, each of which has different tax implications.
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How Can I Save Money By Switching To Wealthsimple Invest
We charge a fraction of the fees that traditional mutual fund investors pay. Our management fee is 0.5% , plus underlying fund fees of about 0.1%. The average mutual fund investor pays 2% in fees.
Our smart technology helps keep your portfolio on track with auto-deposits, automatic rebalancing, and dividend reinvesting. And, we have a team of experienced financial advisors available to answer your questions and provide advice – whenever you need it.
Note: the total savings above, calculates the what you’d save if you were investing with Wealthsimple Invest compared to a traditional mutual fund investor. We compare the growth of your current savings between now and your retirement based on the rate of return selected. All figures are for illustrative purposes only, actual results will vary and fees among other factors are subject to change.
Start Living On A Budget And Tracking Your Expenses
The fact is that until you know where your money is going each month youre going to have a hard time finding money to set aside for retirement savings.
The reason its so important to discover and track where your money is going each month is so that you can identify wasteful spending and reroute it toward causes that are more important to you.
Many people find when they start tracking expenses that they are spending money in $5, $10 and $20 increments that seems like its not a lot but adds up to hundreds or thousands of dollars each month.
When my family started tracking expenses in 2013, we were able to cut them down by nearly $1,000 a month and we were making well under $100,000 per year at the time.
By trimming grocery expenses, cutting back on entertainment costs and being more mindful of each purchase, we found a lot of waste in our spending. We were able to use what we were wasting for much more important things, such as paying off our debt.
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If You Dont Qualify Through The Cares Act
If you dont qualify for special accommodation through the CARES Act, then you will have to pay a 10% penalty on withdrawals from your 401 as well as income taxes on amounts you take out. With a traditional 401 loan, on the other hand, you may be limited to borrowing just 50% of your vested funds or $50,000, whichever is less.
However, you should note that the IRS extends other hardship distribution categories you may qualify for if youre struggling financially . You can read about all applicable hardship distribution requirements on the IRS website.
What Does It Mean To Be Vested
Vested is a term used to talk about how much of your 401 belongs to you if you leave your job. The money you contribute is yours, but some employers have guidelines about how much of their matching contribution you can take with you.
For example: If your company increases the amount you are vested in by 25% every year, leaving your job after only two years would mean you could only take 50% of the employer contributions to your 401 with you. Once youre fully vested, you keep 100% of the employer contribution. Your HR department can provide specific information about your companys vesting guidelines.
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Should I Manage My Own Retirement Account
There are pros and cons to having a professional investment advisor manage your 401. And for some, it may not make sense. After all, not everyone needs a financial advisor. When it comes to making decisions about your finances, focus on the intersection of what matters and what you can control. Using that lens, here’s when to consider managing your own retirement plan and when to ask for help.
For Financial Independence In Retirement
The 401 makes it easy to build wealth for retirement. Once you set your preferences, the work of saving and investing happens behind the scenes. Plus, you have tax savings and, possibly, matching contributions that expedite your savings momentum.
Here’s what it comes down to: The earlier you start contributing to a 401, the more you’ll get from its perks and the richer you can be when you retire.
Planning for retirement when you’re your own boss.
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Should You Work With A Financial Advisor
Setting your investments on autopilot is not an investing strategy you can count on.
You need the experience and knowledge of a financial advisor or investment professional to help you make well-informed decisions about your investments. A pro will help you understand where your money is going and will answer questions you have about how your 401 plan works.
Your financial advisor may not get paid from helping you make decisions about your 401, since your 401 plan is sponsored by your workplace. Or they may choose to charge a one-time consultation fee. Regardless, you can ask on the front end to make sure there are no surprises.
If you want a solid retirement plan, work with a true pro to create a long-term strategy for your investments. You want a pro who is smarter than you but always knows you call the shots. After all, no one cares more about your retirement than you.
Need help finding a pro? With our SmartVestor program, you can find a financial advisor to help you understand your 401 and how it fits in your overall retirement plan.
Option : Keep Your Savings With Your Previous Employers Plan
If your previous employers 401 allows you to maintain your account and you are happy with the plans investment options, you can leave it. This might be the most convenient choice, but you should still evaluate your options. Each year, American workers manage to lose track of billions of dollars in old retirement savings accounts, so you should make sure to track your account regularly, review your investments as part of your overall portfolio and keep the beneficiaries up to date.
Some things to think about if youre considering keeping your money in your previous employers plan:
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Withdrawing From Your 401
The 401 is intended to be a retirement plan, so withdrawals are restricted in your younger years. There are a few exceptions, but most withdrawals before age 59 1/2 come with a 10% penalty.
Retirement withdrawals: You can start taking retirement withdrawals once you’ve reached age 59 1/2. You may be able to begin withdrawals at age 55 without penalty if you no longer work for the company. These withdrawals are taxed as ordinary income.
Required minimum distributions: If you don’t need the money, you can leave it in the account until you are 72. In the first quarter of the year after you turn 72, the IRS requires you to take taxable withdrawals annually. These are known as required minimum distributions, or RMDs. The amount of your 401 RMD for each year is based on your age and your year-end account balance.
401 loan: Your plan may allow you to borrow against your 401 balance, which would not incur a penalty. You do pay interest on the loan however, youre paying interest to yourself. And, if you change jobs, you normally must repay the loan by the time your next tax return is due.