401(k) Basics

The Magic of Tax-Deferred, Employer-Matched Investing

401(k) Basics
May 16, 2016

The savings vehicles known as 401(k) plans were created in the Tax Reform Act of 1978 (through Section 401, paragraph (k) of the tax code, in case you wondered where the parentheses came from). It's grown into one of the most popular retirement savings programs in existence for three major reasons:

  • Employer Contributions – You and your employer can both contribute to your retirement plan. In essence, you’re receiving free money from your employer.

  • Tax-Deferred Status – Your 401(k) contribution is made with pre-tax dollars, and the money is tax-deferred until you draw it out, (presumably upon retirement, when you are probably in a lower tax bracket). The added benefit is a lower taxable income in the investing years.

  • Ease of Use – 401(k) deductions are automatic based on criteria you choose. Employers generally provide several investment options for you from which to choose. You will receive the means to periodically change your portfolio (typically online). Also, since the money is automatically deducted, you never see it — and you adjust your budget accordingly. Saving becomes easy.

How can you beat that? The answer is: you can't. There are many online calculators to illustrate the benefits of 401(k) investing, but let's use an example:

    You are a fresh-faced young employee, starting from scratch with a $60,000 annual salary and a 401(k) that allows you to contribute 10% of your salary, with the employer matching at a 50% rate. Let's conservatively assume no raises in a 10-year period (wow, times must be tough) and a 6% hypothetical rate of return.

    In ten years, if you contribute the maximum, your 401(k) will have $123,524. Your contribution was $60,000. Without employee matching, at the same 6% rate of return you would have $82,349. To get the same $123,524 without employee matching, your investments would have to average a return of slightly over 13%! This clearly illustrates the magic of the 401(k) and why the employer contribution is so important. Imagine getting a 13% return in an economy so bad that you didn't get a raise in ten years!

There are some limitations with a 401(k) plan. Individual contribution limits change periodically to account for inflation; in 2016, the employee contribution limit is capped at $18,000 (if you're over age 50 you can add another $6,000 as a "catch-up" contribution). Employer matching contributions are limited to 25% of your salary, and the collective limitation in 2016 is $53,000. Employers may set lower limits if they choose.

There will be a threshold value of employee contribution to trigger employee matching, but to take full advantage if you can you should be contributing well above this threshold.

There's typically a two-to-three year vesting period before employee-matching contributions become yours. The money you invested is yours, along with potential investment returns on that money, even if you leave the job during the vesting period. Should you lose your job, you are permitted to roll the money into another 401(k), potentially leave the money in your current 401(k) plan, or IRA Rollover. If the money passes through your hands it's considered cashing out and subject to taxes and an early withdrawal penalty. Additionally, if you withdraw your money before age 59.5, you will pay a 10% penalty on top of the tax to be paid.

These limitations are all modest compared to the benefits of 401(k) investing. In summary, if a 401(k) plan is provided by your employer, take advantage of it to the fullest extent you can. Your yearly limit on contributions is higher than that of an IRA, and given the employer matching and tax deferred aspects, makes a 401(k) retirement savings plan very attractive.

The hypothetical example presented is not representative of any specific situation or investment product. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.

Winnie Sun is a registered representative with, and securities offered through LPL Financial, member FINRA/SIPC. Investment advice offered through Sun Group Wealth Partners, a registered investment advisor and a separate entity from LPL Financial.

Let the free MoneyTips Retirement Planner help you calculate when you can retire without jeopardizing your lifestyle.

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