A Deep Dive into 401(k)

 

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So, what motivates me to write this article?  I have friends who make 6 figure salaries, have extra savings every month, and think contributing fully to a 401(k) is a silly idea.  I also have friends who make much less,  carefully budgeting to make ends meet, who opt out of their 401(k) completely, not realizing they could save thousands simply contributing a minimal amount to get free match.  And for myself, when I started working, I only knew the basics about 401(k) thus missed after-tax 401(k) contribution completely. Regardless of your situation, understanding how a 401(k) works can make a significant impact to your personal finances.

Personally, I think  401(k) is a great retirement tool that everyone who can, should take full advantage of. In this post, I will first provide some basic facts about 401(k)’s, and then go deeper into specific aspects of a 401(k). Regardless how much you may already know about 401(k)’s,  you might be surprised by a little bit of knowledge you were not aware of.

 

If You Know Nothing About 401(k)

If you have never heard about 401(k), please read the basics here , or google 401(k) to get some answers. For your convenience, a few facts are listed below:

  • 401(k) is an employer sponsored retirement plan.
  • The fund/stock options you are allowed to invest in inside your 401(k) are decided by your employer, but you  get to decide how to invest from these options.
  • The money contributed to a 401(k) is pre-tax.
  • There is a maximal allowed contribution per year. (In 2016, it is 18k per individual).
  • Most companies match 50-100% of your contributions, up to about 3-6% of a person’s annual salary.
  • There is a 10% early withdraw penalty if you take your money out before retirement age (though there are strategies that can allow you to avoid this penalty).
  • You can take a loan from your own 401(k) for certain purposes, such as purchasing a house, education, medical bills, etc.
  • The money in a 401(k) belongs to you. It will stay intact even if your company goes bankrupt, unlike a pension. It also can be transferred with you when you switch jobs.

 

Tax Benefits of 401(k)

In this section, I mainly talk about the tax benefits of 401(k), which is the No.1 reason that you should contribute to your 401(k) in my opinion. After all, without any tax benefits, we can save for retirement any place we want, why inside a 401(k)?

Let’s first use a little math here. Table 1 lists 2015 taxable income brackets. The maximal tax you can save is your contribution amount times the highest tax rate your income puts you in. ( It is not entirely true since tax brackets are graded, but doesn’t hurt the point I try to make) For example, if you are married and your joint taxable income is $100k, this would put you into the 25% tax bracket. If you contribute the maximal allowed amount $18,000, you would save $4500 in taxes( $18,000*0.25), as shown in the last column.

Tax Bracket Single Filers Married Joint Filers Maximal Tax Money Saved
15% $9225 to $37450 $18450 to $74900 $18000*0.15 = $2700
25% $37450 to $90750 $74900 to $151200 $18000*0.25 = $4500
28% $90750 to $189300 $151200 to $230450 $18000*0.28 = $5040
Table 1. 2015 Taxable Income Brackets and Rates

This is just the first level of tax saving. The key idea is to use your 401(k) contribution to reduce your taxable income, so that you can qualify for tax benefits that you may otherwise not be eligible for.

Sweet Spot One:  Student Loan Interest Deduction. Lots of people pay student loan interest, however, you can only deduct student loan interest if your modified adjusted gross income(MAGI) is less than $80,000 ($160,000 if filing a joint return). For example, if your MAGI ( as single) is $85k before making any 401(k) contributions, you cannot deduct student loan interest, after contributing $5001 to your 401(k), voila, now you can deduct!

Sweet Spot Two:  No tax for Long Term Capital Gain and Qualified Dividend Income.  Do you know that if you are in the 10% and 15% tax bracket, you don’t need to pay any tax on qualified dividends and long term capital gains? Once again, if contributing to a 401(k) can reduce your MAGI so that your tax bracket falls from 20% to 15%, all of sudden you don’t need to pay tax on the profits you made selling some stocks/funds held for more than a year.

Sweet Spot Three:  (Roth) IRAs contribution income limit. Both Roth IRAs and traditional IRAs are great retirement tools. However, if you make too much, you may not be able to contribute to Roth IRAs at all, and you may not be able to claim tax deductions on your traditional IRA contributions.

In 2016, If you are single and your MAGI is less than $117,000, you can contribute to a Roth IRA; If you are married, your MAGI must be less than $184,000. Similar income limitations apply to traditional IRA tax deduction eligibility. See more details here.  By reducing your MAGI by contributing to a 401(k), you may then qualify to contribute to a Roth IRA, and also claim tax deductions on a traditional IRA.

So if you have free money left at the end of each month and have yet to contribute the full amount to your 401(k), do yourself a favor, see how contributing more money can save you more on your taxes. You not only pay less to the IRS now, you also pay your future self significantly more through the magic of compound interest and by letting your money grow tax-free inside your 401k, talk about win win! 

How Much Should You Contribute?

You probably know the answer to this question if you are aware of the tax benefits. Yes, contribute as much as you can. The minimal contribution should be whatever amount your company would match. If your company matches up to $4000, then regardless what your money situation is, please contribute at least $4000. Why throw this free money away? Read here to know more about company 401k match.

Argument One: I don’t have any money to contribute to my 401(k).  I have heard people say, “oh, I know my company can match me up to 4k if I contribute, but I just don’t have the available money to do that!”  This is a TOTALLY INSANE argument, and I will show you why (more math).

I am going to give an extreme case here to illustrate my point.  Let’s say my 401(k) contribution is ZERO.  I truly have ZERO money left over after paying my bills. Here is what I can do. I borrow 4k even if it means borrowing from credit cards ( Let’s say 15% interest for 3 months), and  contribute the 4k to my 401(k). After my company match of 4k, now I have 8k in my 401(k). I will take the 8k out paying the penalty of 10% because of early withdrawal, which gives me $7200. After paying the 4k I borrowed plus interest ( 4k*0.15/12*3= $150, assume borrowed for 3 months here), I now have effectively given myself $3050 ( $7200-$4150) in free money .   See, it doesn’t matter if you have extra money or not, find a way to work around it to get the free match money, PERIOD!

( Please note I am not advising you to borrow from your credit card, and take out of money from your 401k. However, giving up free matched 401k money is a worse decision than borrowing money to get the free match )

Argument Two: I am afraid to contribute too much to my 401(k).  It is very common for people who have extra money to choose to invest their money in taxable accounts instead of maximizing their 401(k) contribution.  The logic is, If I contribute 5k a year for 30 years, I would probably have enough for retirement; If I put in more, and need money at some point in my life before retire, I cannot take the money out.  Thus it seems better to keep any extra money outside a 401(k) that way it can be accessed anytime it’s needed.

There are some fundamental flaws in this logic as I see it. First of all; if contributing 5k for 30 years is enough for retirement, why not contribute 18k per year for 10 years first, and let the money grow all by itself? ( We all know snowball effect, right?) You can decide whether to contribute less after 10 years.

Second of all, if you truly want to take money out of your 401(k), there are multiple ways. First, you can take a loan against your 401(k) for buying a house, education, or medical expenses, without incurring any penalty.  Since you pay the interest to yourself, there is no real cost to you. Second, every time you change your job, you can actually convert your 401(k) to an IRA or Roth IRA. Once the money is in a Roth IRA, even if you pay tax when you do the conversion, your money then grows inside a ROTH IRA tax free, and you can take your money out anytime you want after 5 years without any penalty.  So, money in a 401(k) can be accessed before age 60.

Third, depending on the tax benefits, even if you have to pay the 10% penalty to take the money out, you may still end up with a better deal due to the significant tax saving you have over the years.

Last, putting money in a taxable account may give your more flexibility, but being flexible in investments is a double-edged sword.  Various studies (here, here, and here ) show that most people do much better just to leave their money alone regardless of the market conditions, instead of trying to time the market, or pick the next APPLE.

 

Argument Three: the investment options in my 401(k) are really bad.  Since 401(k) is a company sponsored retirement plan, each company gets to decide on a pool of investment options. If unfortunately the only options you get are funds that charge expensive fees yet perform poorly compared to simple index funds over long periods of time, it might make sense to just contribute the minimal amount, get the free match from your company, and invest the rest of your money some place else.  Of course, make sure to do your math first,  compare the tax advantages you can get, the extra fees, as well as opportunity cost of the bad performing funds, and then make a decision.

 

How to Take Money Out of Your 401(k) Early?

The money inside your 401(k) is meant for retirement, thus if you take out the money early, you have to pay IRA 10% early withdrawal penalty tax. Below lists the basic withdraw rules:

  1. If you are older than 70½, you are legally allowed to take out your money
  2. If you are between 59 ½ and 70 ½, still working,  you can withdraw from your 401(k)’s from your previous jobs, but not the current one.
  3. If you are between 55 ½ and 59 ½,  retired, and terminated employment after reaching age 55, you can take out your money without early withdrawal tax from the year you retire.

 

What if you want to take out your money before age of 55 without paying any early withdraw penalty? First of all, if you still work and just want to take out the money to spend it,  PLEASE DON’T! If you happen to retire before 55, then congratulations, you deserve to take the money out if you want to. After all, 401(k) is for retirement. There are several options:

Option 1: Convert 401(k) to IRAs when you change or quit your job. IRS allows you to roll over your 401(k) money to IRAs when you change or quit your job without paying any early withdraw penalty.   You can convert it all at once, or whatever amount you want in multiple transactions over a long period of time.  Make sure you convert it to a traditional IRA, in this way, you don’t need to pay any taxes during the conversion.  Then, you can slowly convert money from your traditional IRA to Roth IRA. This converted money (traditional IRA to Roth IRA) is counted towards your taxable income.  Since you now are retired ( Why do I say retired here? Your really shouldn’t take out any money before 55 unless it is because of early retirement) your income tax bracket is most likely lower compared to when you were working. Why convert into a Roth IRA? Not only does the money grows in a Roth IRA tax free, you can take out the money without paying any taxes as long as the money has been in your Roth for over five years.

Option 2: The substantially equal periodic payment . This is called a Section 72(t) distribution, which is available to anyone with a 401(k) plan, regardless of age. Based on the rule, you can take out substantially equal periodic payments from your 401(k)  started at any year you choose, but once you start the withdraw, you have to continue withdrawing for 5 years or until you reach 59 ½, whichever is longer. ( So if you start withdrawing at age 40, you have to withdraw every year for 19 years till you reach 59 ½ ) If you stop withdrawals, all funds that have already been withdrawn are subject to early withdrawal penalties.

So, how much will you receive in the periodic payments?  IRS allows you to use three methods: the amortization method, the minimum distribution also known as life expectancy method, or the annuitization method. You can use the 72(t) calculator to get the payment based on your specific situation.

As you can see, putting too much money in your 401(k) is really not a problem. If you save enough and are able to retire years before 55, you can slowly convert your 401(k) money into your Roth IRAs and take whatever amount out of your Roth, or take an equal amount of payment every year from your 401(k) based on the 72(t) rules.  The key is, put in as much as you can when you are working and are in a higher tax bracket, and then take it out using various retirement accounts when you are ready to retire.

After-tax 401(k) Contribution

If your income is high, after fully contributing to  all your retirement accounts including 401(k), traditional and/or Roth IRA, HSA ( Health Saving Account), and you still have extra money, or if your income is too high to qualify to contribute to a Roth IRA, you may consider after-tax 401(k) contributions.

So, what is after-tax 401(k)? It is a type of deferred 401(k) sub-account. You can contribute up to a certain amount ( up to $53000 in 2016) into your 401(k) with after-tax money. But the money can grow tax-free inside your 401(k), just like a Roth IRA.  If you don’t like your 401k investment options, you can rollover the after 401(k) contribution to a Roth IRA account.   Basically, it is a strategy that allows you to contribute significantly more money to a Roth-IRA account per year.

Before you decide whether to make after-tax 401(k) contributions, please make sure to:

  1. Check if your 401(k) plan Administrator allows post-tax contributions. If so, what’s the maximal allowed amount.
  2. Check if your 401(k) plan Administrator allows you to withdraw after-tax contributions without penalty or fees
  3. Check with your Roth IRA custodian to make sure they don’t count your rollover as a regular Roth IRA contribution.

Think about it. If you and your spouse’s companies both allow after-tax 401(k) contributions up to $53,000 a year, you can contribute $18,000*2 before tax, $53,000*2 after tax ( which then can be  converted to your Roth IRAs).  Your $106k will be able to grow inside your Roth-IRA tax free. And you will never need to pay any taxes on this $106k and its compounding gains.  Also, you will be able to take out this money after five years if you desire to.

 

Other Benefits of  401(k)

I hope I already convinced you at this point to contribute as much as you can to your 401(k), and even contribute after-tax 401k. There are a few other benefits worth mentioning.

Asset Protection Your money inside 401(k) is protected pretty much from almost any creditors ( except government organizations), bankruptcy, legal judgements, etc. Your IRAs could be seized in legal actions, but your 401(k) is better protected.  After years of saving for retirement, the last thing you want is to lose your money because of some unexpected lawsuits.

Investment Protection They say the worst enemy in investments is yourself. We all know that we should focus on long term performance and totally ignore day-to-day market fluctuations. Buy low and Sell High! Unfortunately, in real life, people panic and sell their stocks when market is tumbling, and get greedy and buy when the market is over-priced.  Consider your 401(k) as a lockbox that you only put money in, and never take money out. When you have the urge to do anything to your 401(k), think how insignificant your action would be from the perspective of 30 years later. If you still cannot control yourself, your 401(k) plan administrator usually has rules forbidding frequent trading.  Just contribute your money, and then forget about it, pretend you never have the money, this way, you will be surprised how wealthy you get when you are ready to retire.

Take Away

  • If you know nothing about 401(k) yet you have 401(k) option at work, PLEASE spend some time to know the basic of 401(k) first
  • If you live paycheck by paycheck, please contribute at least the amount that can be matched from your company, even if it means borrowing to contribute.  You should never throw away free money!
  • If you have extra money, contribute the maximal allowed amount. Contributing to 401(k) will lower your taxable income, thus may make you eligible for tax benefits that you would not otherwise qualify for, such as student loan interest deduction, no tax on long term capital gains and qualified dividends, eligibility to contribute to Roth IRA or  tax deduction on traditional IRA contributions.
  • If you still have extra money, contribute after-tax money to 401(k), and then convert to Roth IRA if it is allowed by your company
  • If you retire early before 55 and want to take out your 401k money without paying early penalty,  you can convert 401(k) slowly to Roth IRA or receive substantially equal periodic payment.

 

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