What is a 401K? Complete Guide to This Retirement Plan

What is a 401k?

Recent surveys show that only 23-percent of millennials save a portion of their income. Of this 23-percent, the research shows that Americans between the ages of 21 and 37-years old prefer safe investment vehicles, and tend to avoid investing in high-risk assets, such as stocks.

Saving is a critical part of building our future. With so many Americans living from paycheck to paycheck, it makes one wonder how these people will survive in their retirement years. If you have no clue on saving and investing, and you’re in the millennial age group, it’s vital that you understand the importance of putting money away at the end of the month.

Investing for Dummies – What You Need to Know

When people think of investors, most think of men in their early fifties, dressed in a $3,000 suit, puffing on a Cuban cigar while they stare at a ticker board in their 5th avenue corner office. However, this image of “success” does not fit everyone, and you don’t need to be a master of the universe that’s working on Wall Street to take advantage of saving and investing your money.

So, where do you start if you’re a newbie saver or investor? The idea of having savings and investments is to put your money to work for you, instead of working for your money. Your income is a representation of the hours you spend toiling at your job. For most of us, we won’t be earning millions of dollars a year, and every penny we save counts toward achieving our retirement goals.

Investing allows you to choose a vehicle and park your money in this asset, allowing it to grow over a specific term. When the contract ends, you receive your initial starting capital, plus a return on your money for investing it in the asset class.

There are thousands of investment vehicles available – So, which one will suit you? Speak to any professional investor, and they’ll tell you the most critical part of investing is understanding risk versus reward.

Investing in risky assets, such as stocks, may yield fantastic returns that could double or triple your money in as little as a quarter – but it could also wipe out all of your money in a matter of minutes if the market goes the wrong way. This example is a clear indicator of the risk versus reward conundrum.

On the flipside, a savings account is low-risk, but the rewards aren’t high, and you’ll be lucky if you earn any interest on your money at all – all you’re doing in this example is building your capital base.

The Beginners Dream – The 401(k)

We’ve all heard about the 401(k) investment plan. The chances are your company uses this financial vehicle to provide its employees with a means to invest in their retirement.

Simply put, the 401(k) plan allows you to take a portion of your income and apply it to an investment vehicle that’s managed by a professional investor at a credible financial institution. In some cases, your employer will match your monthly contribution into the fund, allowing you to benefit from a doubled savings rate.

The asset management firm then takes the pooled funds and invests it into a portfolio of assets, which may contain property, stocks, bonds, and other financial vehicles. The fund manager spreads the risk across many different asset classes to “diversify” the portfolio. This strategy means that should one asset class fail; the other assets will not be at risk.

Depending on the management company, the 401(k) investor may have the option to choose a low, medium, or high-risk profile for their investments. This tiered risk structure defines the types of assets held in the portfolio.

For example, a low-risk 402(k) may invest the funds in property and government bonds. These assets are traditionally low-risk, but they also offer low returns. The flipside would be a portfolio of assets containing stocks, business loans, and equity in companies.

This strategy is far riskier, and should the company fail, you 401(k) might lose a substantial amount of money. However, if it plays out the way the advisor expects, you could be looking at an excellent return on your capital.

How 401(k) Works

The 401(k) is not rocket science, and portfolio managers offer the product to people who are not savvy or accredited investors. The idea behind the 401(k) is the fact that you are not a professional investor. Therefore, you should trust a qualified and experienced investor to handle your money for you. As a result, you pay a percentage of your earnings to the management team in return for their services.

You make a monthly contribution from your paycheck towards your 401(k) plan, and continue to do so until your retirement. When it time to leave the workforce and rely on your nest egg, you withdraw your money to fund your retirement years.

The 401(k) has some rules you’ll need to follow to make the most out of your investment. 401(k) plans require you to leave your money in your 401(k) account for a specified duration of time, (anywhere from 20 to 40-years.)

There are plenty of 4012(k) plans available, each with different characteristics. The primary difference and concern for newbie investors is the tax they have to make on their contributions and distributions into and out of the fund. The popular plans for Americans include the traditional 401(k), as well as the Roth 401(k) – but what’s the difference between the two?

Complete Blooom Review

Read: Blooom Review: A Robo-Advisor for Managing Your 401k

The Roth 401(k) Explained

The Roth 401(k) gets its moniker from Senator William Roth, who decided to create the plan some twenty years ago. Bills vision was to turn Americans back toward a culture of saving rather than spending. At the present moment, Americans are experiencing the highest consumer debt levels in the history of the country, along with the lowest savings rate on record.

Senator Roth’s idea was to put the American people back into a position where they can benefit from making monthly contributions to their retirement – without limiting their taxable income.

Traditional 401(k) Vs. Roth 401(k)

The primary difference between a Roth and traditional 401(k) resides in its taxation of contributions and distributions.

The Roth 401(k) model as outlined in section 402A of the Internal Revenue Code, was a part of the Economic Growth and Tax Relief Reconciliation Act of 2001. The act cut income tax rates in the wake of the 2001 recession, creating the Roth 401(k) to increase tax-deductible payments into IRA accounts.

Contributions to a traditional 401(k) come from the employee’s pre-tax income, and Roth 401(k) contributions come from the net income of the employee after paying taxes.

When it comes time to distribute the funds in the 401(k) account, the traditional model requires you to pay taxes on your gains. The Roth 401(k) model differs in the sense that there is no taxation on the profits you make with your money, providing a tax-free payout.

Therefore, with the Roth 402(k), you pay more taxes now but receive a significant tax break down the line when it’s time to cash out for your retirement.

As an example, a 35-year-old woman with an annual income of $80,000 – contributes $5,500 to a Roth 401(k) every year until she retires at the age of 67, may end up with the investment yielding $518,000 in savings at a return of 6-percent per annum.

With a traditional 401(k) model, the woman is now eligible for a 25-percent tax rate on her profits. However, with a Roth 402(k), the woman now owes the IRS nothing. While this may sound like a dream come true, it’s important to point out at this time that she was in a higher tax bracket while working, paying 30-percent of her income and investments to the taxman.

However, since the post-withdrawal tax on Roth 401(k) plans are tax-free, she benefits from a $130,000 saving, allowing her to benefit from more money at her retirement.

With traditional 401(k) models, you are not allowed to withdraw your capital until your fixed retirement date. Should you choose to violate this part of the contract and withdraw your funds early, the contract will have clauses stating the financial services provider will penalize you for early withdrawal.

With a Roth 401(k) model, you can withdraw all or a portion of your funds at any stage of the investment term, with no penalty fee. This feature makes a Roth 401(k) the ideal model for anyone looking to save for their kids’ college tuition or a down payment on some real estate.

Research shows that millennials prefer Roth 401(k) plans to the traditional model, and they are more likely to make contributions to the Roth 401(k) than baby boomers or GenXers. It’s important to note that not all companies offer the Roth model, but for those that do, they find that more than 60-percent of employees opt for the Roth 401(k) over the traditional model.

Limitations to the Roth 401(k)

The tax incentives for the Roth 401(k) are so generous that the government decided to place a cap on contributions to this plan. Holders of Roth 401(k) accounts may contribute up to a maximum of $6,000 per year to the investment, with those individuals over the age of 50-years allowed contributions up to $7,000. You can fund a Roth 401(k) account for 2019 through to the April 2020 tax deadline.

The Internal Revenue Service also limits who can apply for a Roth 401(k). The Roth 401(k) launched as a financial savings vehicle for the middle class, allowing them to make returns on their money to fund their retirement. The IRS does not feel that high-earning individuals qualify for this model, and restricts contributions to a Roth 401(k), or denies the use of the vehicle to high-income earners.

The early withdrawal benefit and tax-free incentive of a Roth 401(k) are attractive, but it’s critical to understand that this only applies to contributions, not to earnings. Should you choose to withdraw earnings before the end of the contract maturity date, you’ll experience two penalties; a 10-percent penalty, plus the taxes you pay on the amount withdrawn.

The “pay now, save later” feature of Roth 401(k) plans allows you to build up your capital paying tax in your current tax bracket. When you retire in a higher tax bracket, you don’t owe the taxman any backdated amounts on your previous taxable income.

Including the Roth 401(k) in Your Investment Strategy

The Roth 401(k) is best suited for young people entering the workforce. During the early years of your career, the chances are that you’ll be in a much lower tax bracket than when you reach the peak of your career in your forties and fifties.

Therefore, you benefit from contributing to your Roth 401(k) in the formative years of your career, as the tax you pay on contributions is lower than in the later years. Since the Roth model does not require you to pay any tax on your funds when you withdraw during your retirement, you benefit from the lower-taxed contributions early in your career.

Tips for Selecting a Roth 401(k)

There are thousands of brokers online offering a variety of 401(k) plans. Should your employer offer a 401(k), you can choose to take up their offer – or go out on your own with an external plan from a broker. It’s important to note that you should start by investigating your employer’s plan. Most employers match the contribution made by their employee, allowing you to benefit from a double savings rate.

However, if you have to search for a plan, make sure you take the track record of the firm you’re investing with into account. The last thing you want is to invest in a 401(k) managed by reckless or inexperienced financial managers.

The Roth 401(k) – Key Takeaway

The Roth 401(k) combines the best features of traditional 401(k) plans, along with added tax-break incentives to form a hybrid investment vehicle suitable for those newbie investors that want to take a hands-off approach to money management and investing.

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Oliver Dale is Editor-in-Chief of MoneyCheck and founder of Kooc Media Ltd, A UK-Based Online Publishing company. A Technology Entrepreneur with over 15 years of professional experience in Investing and UK Business. He built Money Check to bring the highest level of education about personal finance to the general public with clear and unbiased reporting.


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3 comments

  1. I found it interesting how you mentioned how properly tracking your 401k investments can help you know when you can retire and when to stay working. My wife and I are approaching generalized retirement age but we don’t want to retire unless we have full benefits. I will keep this in mind as we search for a retirement calculator that can help us understand when we’ll have maximum benefits!

  2. I found it interesting that you state that you don’t have to be a professional investor to have a 401k. My brother is starting his first full-time job and wants to make sure he’s doing everything he can to prepare for the future. I will send him this information so he can look into finding a 401k investment consulting company to help him understand it better.

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