A Complete Guide About The 401(k) Account
The mantra of the Financial Independence, Retire Early (FIRE) community is to be debt-free, save money, and max out your tax-advantaged accounts like the 401(k).
So what exactly is a 401(k)?
In this post, you’ll learn exactly what a 401(k) is, how it works, and reasons why you should or should not max out your 401(k).
What is a 401(k)?
A 401(k) plan is an employer-sponsored retirement savings plan that allows employees to contribute a portion of their income for retirement. The income should be used to make investments offered by the employer’s plan and the plan provider.
The 401(k) originated its name from the relevant section of the U.S. Internal Revenue Code. These plans are typically offered by private sector employers while public sector employees have access to similar plans known as 403(b), 457, and Thrift Savings Plan (TSP).
How a 401(k) Works
Contributing to a 401(k) is optional. As an employee, you decide how much of your salary you want to contribute. Usually, you choose a percentage of your salary and the amount will be deducted from your paycheck.
If it’s a Traditional 401(k) plan, the contribution will be deducted from your paycheck BEFORE taxes are applied and will lower your taxable income.
A Roth 401(k) allows you to contribute a portion of your paycheck AFTER taxes are applied and you’ll be able to withdraw the money without paying taxes at all on any gains.
Employer Match
Many employers offer a matching contribution to incentivize employees to participate in the plan and to also incentivize employees to either join/stay with the company. Depending on the employer, you could get a match that is less than, equal, or more than your contribution.
Vesting Schedule
Oftentimes, employers have a vesting schedule to keep employees at the company. Being fully vested means that you have complete ownership of the employer’s contributions to your 401(k). Anything you contributed will always be yours (aka 100% vested), but depending on your employer’s vesting schedule, you may have to work for a certain period before the employer’s contributions are fully yours.
A vesting schedule can look like this: 4-years to fully vest with 20% vested after your first year with the company, 40% after your second year, 60% after your third year, and 100% vested after your fourth year.
It’s very important to understand your employer’s vesting schedule in case you decide to switch companies before you’re vested.
Annual Limits
The annual contribution limit for 2023 is $22,500 for employees and $66,000 for combined employee and employer contributions.
If you’re 50 years or older, you can contribute an additional $7,500 to “catch-up”, thus raising your employee contribution limit to $30,000.
Investment Options
Your options in what to invest in will vary based on your employer and the plan provider. You can’t invest outside of the plan’s options. Typically, 401(k) plans offer a variety of mutual funds, target-date funds, and index funds.
Carefully review the options before deciding on the allocation of your investments. You can automate this in your provider’s portal like 50% towards one mutual fund and 50% towards a target-date fund.
Penalties of Early Withdrawal
Withdrawals are allowed (without penalties) at the age of 59 ½. If funds are withdrawn before, you’ll incur a 10% early withdrawal penalty as well as income tax on the amount withdrawn in a traditional plan.
Why Maxing Out The 401(k) May Not Be The Best Strategy
It may be an unpopular opinion, but it’s true. Maxing out your 401(k) is not the best for everyone. I hate to be the typical consultant with this answer, but it really depends on your goals.
Here are some scenarios when it would likely make sense to max out your 401(k):
Scenario 1: You plan to work until traditional retirement age and you want to be completely passive with your investments. Then maxing out your 401(k) makes total sense!
Scenario 2: You earn a high salary and maxing out your 401(k) won’t impact your lifestyle. You also don’t plan to aggressively pursue early retirement. Then maxing out your 401(k) is a great move!
Scenario 3: Your employer offers a dollar-to-dollar match with immediate vesting. It’s rare for employers to be this generous, but they exist! Maxing out your 401(k) would be a GREAT idea to get a 100% ROI for your money.
Overall, if your employer has a great 401(k) contribution, you don’t plan to retire early, your lifestyle won’t be drastically affected by maxing out, and you want completely passive investments, then maxing out your 401(k) can make sense.
Here are some scenarios when it would likely NOT make sense to max out your 401(k):
Scenario 1: You’re aggressively pursuing early retirement with real estate and your employer’s match is decent. It may make sense to either contribute to get the employer’s match or to not contribute at all. Depends on how long it’ll take to vest and how long you envision yourself at the company.
Scenario 2: You’re trying to grow your real estate portfolio. You plan to job hop every year or two in order to increase your W-2 income to invest more into real estate. Your employer’s contributions only vest completely if you stay at each company for four years. It might not make sense to contribute into the 401(k) plan if you focus your income on real estate investments, although it’s recommended to at least contribute to an IRA or Roth IRA.
Scenario 3: You don’t earn enough to not feel the impact on your lifestyle. You’re struggling to invest in other areas because your paycheck after your 401(k) contributions only allow you to pay for living expenses. If you have other passions/investments you want to pursue, it would make sense to get your foot off the gas with your 401(k) so you can diversify. Examples could be you’re looking to acquire a small business or you need money to start your own business, but can’t save enough to do so.
In summary, it might not make sense to maximize your 401(k) contribution if you’re aggressively pursuing early retirement, want to pursue other investments that’ll allow you to retire early, or would live uncomfortably after your contributions.
What I Do With My 401(k)
I talk the talk and I walk the walk so I’m going to share what I do with my 401(k) plan.
My Firm’s 401(k) Plan
My employer matches up to 3% with a 6-year vesting schedule ???? ????.
I’ve been with my employer for almost two years. Once I hit two years at my firm, I’ll be 20% vested with my employer’s match. Every year after that, I’ll vest 20% more until it hits 100% in year six. It’s one of the worst I’ve ever seen.
I don’t plan to stay six years at my company since I plan to “retire” much sooner, but I’ll take the match and see how long I stay. When I leave my employer, I’ll likely roll it over to a new 401(k) plan with Capitalize, which is a FREE service to rollover your old 401(k), if I’m still an employee and the new plan accepts rollovers. Read here on what to do with your old 401(k).
Contribution and Allocation
I contribute 3% pre-tax (to lower my taxable income) and to get the full match that my firm offers. The 3% has no effect on my lifestyle nor investments. It ends up being slightly more than $200 a paycheck.
My 401(k) is 100% allocated to a total market mutual fund with the lowest expense rate in the plan. Since I’m still young-ish, I’m in the market for the long-term.
The Main Reasons Why I Don’t Max My 401(k) Contribution
If I wanted to retire at a more normal retirement age, I would max out my 401(k), but I don’t. I want to retire in my early 30s.
Withdrawing from a 401(k) has tax and penalty implications. An early withdrawal leads to a 10% penalty and to avoid the penalty, there are several ways to do it, but it can be complex and it may not fit my situation at that time.
I’ve been growing my real estate portfolio and I’m looking to own a small business. For those reasons, I would rather have liquid capital. A 401(k) is not as liquid.
Final Words
If you want to be a passive investor and you’re not aggressively pursuing FIRE, then maxing out your 401(k) is probably your best bet. It’s a great account, especially if your employer matches your contributions!
