What’s The Most Important Tool in Your Financial Toolbox?
If you’re not familiar with the federal tax code, 401(k), 403(b), and 457 might sound like the secret numbers you need to find to defeat an escape room. They’re actually the portions of the tax code that describe some of the most valuable tools for retirement investing available to ordinary taxpayers.
In this post, we’ll explain how these plans work. In the next post, we’ll show you how to use yours to reach your retirement goals.
Retirement Plan History 101
Back in the 1970s a group of high-earning employees from Eastman Kodak lobbied Congress to allow a part of their salary to be exempted from taxes and invested in the stock market. The result was included in the Revenue Act of 1978, which added section 401(k) to the federal tax code.
Kodak is a shadow of its former self these days, but the pre-tax retirement accounts created by that section become more popular and valuable every year. Subsequent additions to the tax code created 403(b) plans, which are essentially 401(k) plans for public education organizations, some non-profit employers, some hospitals, and self-employed ministers, and government 457 plans, which provide similar benefits to government employees. (There are also some non-government 457 plans, which follow different tax laws.)
With pensions disappearing, the 401(k) and its brethren are the most popular retirement investment vehicles in America. The American Benefits Council estimated in 2019 that more than 100 million Americans had over $5.7 trillion invested in tax-advantaged retirement plans. At the end of 2019 over 233,000 401(k) accounts had balances of $1 million or more at Fidelity alone.
Becoming a 401(k) millionaire isn’t as daunting a task as it may seem. With time and discipline, that milestone is within almost anyone’s reach.
How 401(k) Plans Work
Retirement plans such as 401(k)s offer a powerful advantage over many other ways to invest: taxes on your gains are deferred until you withdraw the money. That means your investments can grow for decades before you have to pay any taxes.
Your 401(k) contributions are deducted from your paycheck pre-tax, which means before any taxes are taken out. The result is that you’re taxed on less than your full paycheck, which lowers the amount you pay in taxes immediately. Because of the tax savings, your paycheck will probably be larger than you might expect even after contributing to your 401(k). For example, depending upon your income and tax bracket, investing $200 from every paycheck in a 401(k) might only reduce your take-home pay by $160-170. That’s a powerful financial benefit. And it’s just the beginning.
The second benefit to a pre-tax retirement plan like a 401(k) is that, as noted above, you defer all taxes until you actually begin to withdraw your money. For many of us, taxes may be lower when we’re earning less in retirement, meaning we avoided higher taxes in the present to pay lower taxes in the future.
Another Tax-Advantaged Option
The 401(k) section of the federal tax code has another gift. This one can help alleviate the uncertainty of trying to predict your future taxes. Employers can also offer a Roth-401(k), which is funded by after-tax dollars. Instead of realizing immediate tax savings, as a traditional 401(k) provides, withdrawals from a Roth-401(k) are tax free. In other words, the two types of 401(k)s give you the option of paying taxes now or when you start making withdrawals from your retirement account. Either way, your retirement investments come with powerful tax advantages.
And there’s one more benefit that can virtually double your retirement investment overnight. It’s completely legal and, in fact, your employer encourages it.
The Magic of an Employer Match
To help motivate your retirement investing, many employers offer an employer match: when you contribute to your company’s 401(k) plan, your employer deposits a like amount in your account. For example, an employer might match every dollar you invest in your 401(k) up to 3% of your salary. If you make $100,000 a year and put $3,000 in your 401(k), your employer will add another $3,000. Your money just doubled.
This is the textbook definition of free money. But there is a catch.
Often there are some restrictions, such as a requirement that you remain an employee for a year or some other amount of time to be able to keep that free money. This waiting period is called vesting, and it’s fairly common for 401(k) matches and other company benefits, such as company stock options. The free money is worth the wait.
Now that you know how 401(k) and similar plans work, here’s how to use yours to reach your retirement goals.
Interested in learning more about how 401(k)s work? Check out our lunch & learn.