Here, we’ll take a look at key concepts relating to an incredibly important retirement tool, the 401 (k) account. If you’ve done any looking into asset allocation, retiring early, or even employer benefits, you’ve probably heard of this established All-Star within the field of finance.

Disclaimer

I am not a professional financial advisor. The information provided is for educational purposes only. A qualified professional should be consulted before making financial decisions. I am not responsible for any errors, omissions, or the results obtained from using information on my site. The user of this website assumes all risks associated with actions that they take.

Past performance is not indicative of future results. No particular result can be guaranteed. All investments involve risk, often including a potential loss of principal.

What is a 401k?

Let’s start by identifying what a 401 (k) account is. A 401 (k) plan is a retirement savings account that’s (ideally) sponsored by your employer. Often, it’s an elective at your workplace that you can sign up to be a part of by allowing a percentage of your paycheck to be withheld – socked away immediately, before hitting your checking or savings account with the rest of your money.

Think of the 401 (k) as a savings account specifically intended to be used during retirement. It’s part of the long game – this isn’t usually money that will go towards any other purpose than retiring. Its sole purpose is often to replace active income and allow you to leave the workforce.

401 (k) Match – Teamwork makes the dream work

Why would you give up a portion of your paycheck, and why should you be concerned with whether or not your employer sponsors the account? Some employers offer to match the amount of money that you’ve elected to stash away. This is one of the most notable benefits to the account, and an advantage so worthwhile that it’s frequently considered first and foremost to any other savings option..even your savings account itself!

EXAMPLE: Let’s say your employer offers a 5% match. Let’s say prior to any deductions (this would be things such as taxes, health insurance, dental, etc), you get paid $2,000. If you agree to pay 5% of your $2,000, you will begin to contribute $100 to your 401k account. So, your $2,000 check has been hacked down to $1,900 in hopes that you can start to build a nest egg that will one day allow you to leave the work world and support yourself independently, without an active income. Your employer indicates that they will match your contribution into your 401 (k) account up to a maximum of 5%. You save $100 towards retirement, and they add $100 towards your retirement, too.

You’ve agreed to bury $100 from your $2,000 paycheck (leaving you with $1,900 paychecks until your next raise), and $200 makes its way into your 401 (k) retirement savings every time you’re paid. You’ve only subtracted $100 from your pay, but $200 is saved after each pay period. This is the magic of an employer match. It’s free money, and it’s a lot of it – double the amount that it would have been if you had declined the offer to participate at all and maintained your $2,000 paycheck.

What if your employer does not offer a 401 (k) plan? The bad news is that the material in this post is likely not your best reference without an employer-sponsored 401 (k) plan available. The good news is that you still have plenty of great options. If I were seeking retirement account fundamentals without the option of an employer-sponsored 401 (k) plan, I would start by reading up on a Roth IRA account – this will be covered on this website and linked separately as my post on that subject becomes available.

401k Tax advantage- Prior to deductions, grow before you owe

We’ve built an understanding around what an employer match means and why it’s a big deal. Did you notice how I mentioned that the 401 (k) contribution is removed from your check prior to taxes? This moves us towards benefit number 2 – 401k plans are tax advantaged.

For a financial account to be considered “tax advantaged,” it needs to offer a clear benefit in regard to taxes. In the 401’s case, your contributions are added pretax. Referencing our example above, the $100 contribution was stored before any taxes were taken from it (and so was the $100 matched by our employer in this example).

401 (k) plans allow your contributions to enter prior to any taxes, ultimately allowing compound interest to multiply from a greater sum. Come time to access these funds, taxes will be owed based on the tax bracket that you are in at the time of withdrawal. There are nuances to consider and strategies to be aware of that may help to optimize your approach around taxes, but the primary thing to take note of is that your money is not only matched by your employer (win) but also in full, unharmed by tax deductions (huge win) that would otherwise have deteriorated your $100 to something less significant.

Please note, I am not a financial advisor, and you should always consult with a professional when making decisions with your finances – particularly when considering tax implications. I would encourage you to think through the implications of the tax advantage and its relevance to compound interest across a timeline practical to that of retirement.

401 (k) Vesting – Time in the office beats..not enough time in the office

You’ve gained exposure to the following concepts: the 401 (k) as a whole, the idea of employer matching, and the powerful tax advantage that the 401 (k) offers. Too good to be true? Maybe – let’s talk vesting.

While your contributions (if we go back to our example, this would be the $100 that you, yourself, contributed to the account) are typically 100% your own, some employers incorporate a vesting schedule. The amount that they contribute, the other $100 in our example, is sometimes not owned by the account holder right away.

A common example of a vesting schedule is “graded vesting“, where something like 20% might be transferred to your ownership every 2 years or so. In this case you may see the employer matched money within your account, but you might only own 20% of their contributions after 2 years, 40% after 3 years, and so on – until after a set period of time, maybe 6 years, when you are “fully vested“, meaning that the entirety of both your own contributions and your employer’s contributions are yours to own, to transfer, and to bring with you if you go elsewhere or leave the work force.

Other examples of vesting plans include “cliff vesting” (after one set period of time, say 3 years, 100% of employer contributions are your own) and immediate vesting (at the onset of the plan establishment, all employer contributions are your own).

The 401 (k) is largely recommended as a must-have, but it is up to each of us to understand our own employer’s vesting schedule and terms.

401 (k) Withdrawals – What if I need my retirement money early?

Speaking of retirement fund terms, what happens if you need the money that you’ve invested earlier than anticipated? Generally, the relationship with a 401 (k) is to contribute money meant to grow until you plan to retire and to address strategies to optimize taxes and minimize penalty reductions at the time of withdrawal. If you would prefer to have access to your funds earlier than retirement or are saving for a much shorter-term goal, it may be in your best interest to consider options of higher liquidity.

The idea with this account is that the money added to your 401 (k) is money that you won’t miss until it’s ready to fulfill its purpose of fueling your best retirement. In addition to the regular income taxes that you would incur at the time of withdrawal, the IRS enforces a 10% penalty for withdrawals made before the age of 59 1/2. This is a very big deal, especially on top of the already detrimental effect that early withdrawals have on compound interest and any calculations you may have made to calculate pacing for retirement.

There are exceptions and workarounds, including situations involving disability, medical expenses, severe hardship, and a number of other instances. As with all financial decisions, especially those involving tax strategy, I would recommend consulting a professional if you are attempting to access your retirement money early. All and all, most plan to keep that money working right up until retirement.

401k Rollover – Am I stuck at my workplace?

What would happen if the 401 (k) plan seemed to be a good fit for you, you participated for a while, and suddenly you’re not as fond of your workplace as you once were? What if the state of the company changed or you were forced to look elsewhere? We’ll touch on some of these concerns below as we discuss the 401 (k) rollover, alternative places to move your existing funds, and items to consider when attempting to pull your balance.

Moving existing 401 (k) funds from one account to another is referred to as a rollover. You’re usually able to bring your full contributions, as well as some or all of your previous employer’s contributions, depending on their vesting schedule when switching companies. This is usually a process that can be resolved in a few phone calls that could involve your previous employer’s HR department and or your new employer’s HR department.

This may be a good time to review all retirement account opportunities and review your objective. Keep in mind your tax bracket and what that could look like at the time of retirement, as well as the expected timeline in which funds will need to be accessible. Another retirement account, such as a Roth IRA, could be a strong consideration as it’s just as easy to roll over your 401 (k) into a Roth during this adjustment period. You should always consult with a professional to discuss these changes and to thoroughly understand all of the implications.

To recap this section, here are a few of your options when leaving the employer who sponsors your 401 (k) plan:

1.) Roll your 401 (k) over to your new employer and continue with your current strategy, keeping in mind your new employer’s match (or lack thereof).

2.) Look into alternative retirement accounts in addition to or in place of your current system.

3.) You could consider withdrawing your funds at this time, but it is unlikely to be the best option, as it would be challenging to avoid early withdrawal penalties and could do serious damage to your long-term retirement pacing.

4.) You may have the option to keep your funds with your previous employer. It’s a good idea to review their terms to understand if anything would happen to your money after a period of time, and to confirm whether or not you would still be able to contribute to the account. It is not likely that your previous employer would continue to match any of your contributions (if you still had the option to contribute at all).

401 (k) Investments – Tried and true

You now understand what a 401 (k) account is in general. You’re aware of the reasons it should be a real consideration for most employees with the option available. You even know of a few weaknesses and pitfalls the account could present. What happens inside the account? Where does the money go? In this section, we’ll provide a couple of examples of popular investments.

It should be noted that the options available within your employer’s selection are not universal and will vary per employer. There are accounts and types of accounts that are very similar to each other in many ways. You’ll be able to find things like ETFs and target date funds present in almost all employer-offered 401 (k) accounts. It is up to the individual to learn about their employer’s opportunities and to sort through whether or not they best suit your needs.

ETFs at a glance

ETF stands for “exchange-traded fund”. It’s a single fund that holds a collection of investments. That collection could have an overarching theme. It could attempt to track a specific sector such as energy, financials, or information technology. It could track a market index such as the U.S. equity market as a whole, the S&P 500, the Dow Jones, or the U.S. investment-grade bond market. ETFs offer a strong quality of diversification versus their single company counterparts. They’re highly liquid as they’re traded on exchanges like stocks. Let’s go over a few advantages of ETFs as well as a few potential limitations.

Pros:

• Naturally offers some level of diversification. An individual company may run into negative press and experience hardship without the sector or market of a related ETF feeling the negative impact as heavily (if at all).
• Easily tradable / liquid. Liquidity refers to the ability to turn your asset into accessible cash. Liquidity is determined based on the difficulty of selling the asset, the timeline it would occur in, and the fees around doing so.
• Fees. ETFs that are not actively managed index funds can offer significantly lower fees than actively managed funds, making a dramatic impact on long-term returns.

Cons:

• Inability to customize. It’s important to understand the holdings and exposures included in an ETF. You cannot shift the fund allocations the same way you can when buying individual stocks, and you are bound to the balancing of the fund until you exit the position.
• Differences in tracking. It’s considered a “tracking error” when an ETF attempting to track a specific index yields a result notably different than the index it had set out to track.
• Diversification implications. By diversifying, you tend to limit your downside when things are bad, but it’s entirely possible for a single holding within an ETF to outperform the ETF itself, and in that specific instance, you’ve limited your upside, too, being that the individual high performer is only a percent of your entire holding. This isn’t inherently negative and is mostly a good approach to risk if you ask me. Still – worth noting.

An example of a popular ETF type, a S&P 500 ETF (In this example, I’ll reference “VOO” – Vanguard’s ETF meant to track the performance of the top 500 U.S. companies) has roughly a 14% average annual return over the last 5 years. There’s no disregarding the strong track record of ETFs, especially within an account such as your 401k.

Target date funds

While still likely classified as an ETF depending on structure, a target date fund has some implications that allow it to stand separately as its own consideration within your 401 (k) portfolio. Usually, these funds include the year of anticipated retirement in their title and aim to grow gradually more conservative as the target date approaches. One notable difference between a target date fund and other ETFs is that most target date funds include some percentage of bonds (maybe even a substantial percentage towards their target date), whereas only certain ETFs include bonds at all. Below, I’ll list a couple of advantages and potential pitfalls that target date funds offer.

Pros:

• Naturally offers a great level of diversification. Diversification in not only the same way as most other ETFs, but even a step further in greater exposure to other asset classes, including bonds and possibly REITs (Real estate exposure).
• Automatically rebalanced over time. The fund is set up more aggressively initially in an attempt to capture greater gains and gradually reduces risk through intentional and automatic rebalancing as the target date draws closer.
• Hands off. Due to the built-in rebalancing strategy, there’s not necessarily requirement to manually rebalance your funds. Even if the market reacts unexpectedly, the account may have allocation standards that are preset and kept in check frequently through active management.

Cons:

• Fees due to active management. Because target date funds require some tending to, generally, whoever is tending to them needs to be paid. This can sometimes be compensated in the form of slightly or substantially higher fees charged to the account holder. Fees based on a percentage of returns can hugely impact long-term gains.
• The inability to customize for risk tolerance and risk capacity. Though target date funds are meant to be suitable for the majority of the population, you do forfeit tailoring the plan exactly to your situation and risk preferences by committing to a predetermined allocation balance.
• Inability to pivot as easily. Being that the plan is more comprehensive in the sense of expecting a specific timeline that funds will be accessed, if you do make any changes to the date you begin to access funds, your account may not be optimized for either early withdrawal or to capture the best returns if you choose to delay withdrawal.

This is only the tip of the iceberg when it comes to investment options within your 401 (k) account, but it’s a pretty good bet that either a target date fund or other ETFs will make up a huge percentage of your retirement portfolio for much of your investing timeline. I encourage everyone to review their employer’s options, consult professionals to build a plan tailored to your own needs, and do additional research to ensure that your plan will work in your best interest. Consider tax implications heavily and don’t wait until you’re ready to withdraw money to review things like your company’s policy and tax strategies, as it may affect the numbers you planned around to a great degree.

In summary

This concludes this beginner-friendly introduction to the 401 (k) account. Let’s review all that we’ve covered.

In this post, we’ve discussed the following topics:

• What a 401 (k) account is
• The benefit of an employee sponsor and company match
• How the 401 (k) is tax advantaged
• Vesting and vesting schedules
• Withdrawals and the ability to roll over your account
• ETFs and target date funds

I hope that this post has provided exposure to a few important ideas relating to 401 (k) accounts and has begun to inspire you to put together a retirement plan that will best allow you to achieve your goals, on your timeline, at your pace. I plan to elaborate on all of these concepts in further detail with future posts – be sure to click around the site if you’re ready to dive deeper into any particular topic. Remember – always consult a professional before making any financial decisions. You’re expected to do your own research and to tailor your plan to your specific needs. Past performance is not indicative of future results, and investing involves risk. With these things in mind, I’m confident that you’ll continue to build a strong foundation around finance and more easily accomplish your goals. Good luck, and happy investing!