The financial industry has made a mess and saving for our retirement and task that is not easy to understand and to commit to. All this financial jargon from how old you want to live in retirement to when you will die. I like the one about you will run out of money in x years. They throw all these numbers and projections left and right. Leaving the average American all confused, lost and thirsty for a beer or a vacation. Anything to stop thinking about the retirement years.
In this blog post I will take about one type of retirement account. Later, in other posts, I will talk about other types of retirement accounts. Today, we look at the famous 401(k) or as some make fun of during bear markets, like the recession we are in now with the Covid-19, the 201(k).
Before I go into how 401(k) works, I will share with you all some statistics from a research conducted by Fidelity Investments about the average balance in 401(k) accounts based on your age.
- Ages 20-29 – Average 401(k) balance: $13,200
- Ages 30-39 – Average 401(k) balance: $46,200
- Ages 40-49 – Average 401(k) balance: $111,100
- Ages 50-59 – Average 401(k) balance: $188,000
- Ages 60-69 – Average 401(k) balance: $212,600
Young Americans just don’t save. Part of it has to do with the fact that they are low earners and they are not thinking about retirement. They are thinking more about heading out to the beach to have a great time. Later in the 30s they start thinking about purchasing their first home. So funding a retirement account is at the bottom of the list of priorities. However, the sooner you start the better because you let that money in the retirement account grow over time and take advantage of the bull and bear markets.
What is a 401(k)
These are accounts that are setup by your employer – the company where you work at. Think of these accounts as a savings account like the one you open in a bank that have incentives to get you to save and restrictions to hold you back from taking the money out before your retirement. Remember how I said that the financial industry makes these accounts sound so complicated when in reality they are not. There is so much misunderstanding about these accounts that often people make lots, lots of mistakes handling them and turning them into another tax-generating machine for the government and income-generating machine for the financial advisors managing these accounts.
What’s the incentive?
Tax-deferred
If you put money in these accounts (financial advisors like to use the word contributions) then you get to lower your total income at the end of the year so you can pay less in taxes (financial advisors like to say deductions). That money you put in this account is removed from your salary so it is not calculated on your Federal and State taxes.
Example
My salary for this year was $100,000. I put $19,000 of this salary into my 401(k). What do I pay in taxes. I will assume you are single and I will not use any tax deductions. With that income you are in the 22% tax bracket. How much do I save in taxes?
Here you will see how much you pay if you do not put money into your 401(k), the table of the left and the table on the right you see how much money you save in taxes if you do put money in your 401(k).
If you decide to take all the money from your salary and put $0 in your 401(k) you gave Uncle Sam a nice check for $15,104. Now, if you put $19,000 in your 401(k) you gave Uncle Sam $10,882. That is a difference of $4,222. Now I don’t know about you, but I don’t like giving the government more money than what they need to get from me.
This is one incentive. Sure you will have less money to spend on other things because your real income will be lower since part of it, almost 20% went to your 401(k) and the other 10% to the government. After your 401(k) savings, Federal and State taxes you may be left with $60,000 in disposable income. That’s about $5,000 a month.
Free Money
Free money? What do you mean? Well if your company or the owner of the company is not some cheap selfish person and actually cares about his employees, he will add a feature to the 401(k) that will give you free money if you put some of your own money in the 401(k). Financial advisors or plan administrators like to call this a match. What it means is that if you put $1 of your money, the company will put (match) $1 of their money. Free money. Now the owner of the company can put a cap on how much free money he will give you. For example, he can say I will match $1 for $1 up to 3% of your salary. So if you earn $100,000 and you put $3,000 in your 401(k), then the company will put another $3,000. Total of $6,000. Nice.
Remember that this match is a formula and one company could have one formula while another company has another formula.
For example, say your company tells you that they will match up to 6% of your salary but up to 50% match. In this example if you put $3,000 of your salary in your 401(k) the company will put $1,500 of their own money. Now if you put $6,000 in your 401(k) the company will put $3,000. Basically with this formula they want you to put more of your money into your 401(k).
Loans from your 401(k)
Most 401(k) plans/accounts have a feature that allows the employees (financial advisors jargon call these participants) to take loans from their 401(k) accounts. This is a way for you to use the money you have saved up in the event you have an emergency. You may be asking yourself, loan? Who do I pay the interest to and who determines the interest rate? Well, technically you are giving yourself a loan using your own money and you set the interest rate. Somewhat silly because you are paying yourself an interest on your own money.
The loan is setup this way so that you do not trigger a penalty for taking the money out before your retirement (financial advisor jargon distribution). You see, there are some no-nos in your goal to save for retirement. The IRS hits you with a 10% penalty if you take the money out before the age of 591/2, let’s just say 60 years old. I will get more into this in another blog post. But going back to the loan. I do not recommend you ever, ever take money out of your 401(k) no matter what. Even if it is an emergency. You need to have other accounts set aside for that. For instance, an emergency fund. You see, if you always rely on your 401(k) for emergencies then at the end of your journey you will never get to financial independence. You will not become an Economy Chief if you keep taking money out of your retirement accounts. So forget about the loan provision of your 401(k). Think of this account as one that you have no access to until you are 60 years old. When no-one wants to hire you and your company is eager to let you go because you have become old and are nagging other young employees to much. Plus, you keep telling people that you know everything about the company and “we use to do this this way.” You get my point.
By the way, thanks to Covid-19, on March 27, President Trump signed a $2 trillion coronavirus emergency relief package. It doubles the amount of 401(k) money available as a loan to $100,000. Before this virus mess, you could take up to $50,000 or 50% of your account value (financial advisor jargon calls this vested account) whichever is higher.
You Are Not Getting Any Younger
Sorry I had to say it. Unless you are a twenty year old reading my blog, but even they are getting old. We need to start saving now. Unless you want to spend all of your life working and becoming a slave to the economy. I don’t know about you, but me, Economy Chief, like to save and put that money to work to generate passive income. Your 401(k) is an account that is invested in the stock market. It is invested in mutual funds that are not the greatest – later I will post a blog about my thoughts on mutual funds. But it is what we have. The mutual fund returns in your 401(k) are nothing to celebrate but if there is a match, great. That will offset the poor mutual fund selections, which are typically ten to fifteen.
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