Myth: 401(k)s are a scam.

The idea of a 401(k) being a scam has taken social media by storm recently. My mind goes particularly to one person selling a certain insurance product that is insanely costly.

Anyway, I figured going through what a 401(k) is for a younger audience may be helpful. Not only are 401(k)s NOT a scam, they are an incredible way to save for retirement.

A 401(k) is a tax-advantaged account that employers offer to their employees. It is a turnkey way to begin saving for retirement once you’ve begun your professional career. A 403(b) (for non-profit employees and public-school employees) is very similar to a 401(k).

Common questions about 401(k)s:

1) What type of money can I contribute?

Usually, these types of accounts offer pre-tax or Roth deferrals.

Pre-tax deferrals give you a tax break now, meaning you will not pay income taxes on the amount contributed to the account. You will still pay FICA taxes (Social Security and Medicare). When you withdraw this money during retirement, it will be taxed as income. Essentially, you are making a bet that your tax rate is higher today than it will be during retirement.

With Roth deferrals, you will pay taxes on the money now. It is very similar to a Roth IRA in the way the money grows and is distributed in retirement. You pay taxes on the contributions now and the money grows tax-deferred and eventually is distributed tax-free during retirement.

Many young professionals who have not reached their peak earning potential prefer to pay the taxes today and elect the Roth deferral.

2) What is the maximum I can contribute?

Generally speaking, as an employee you can contribute up to 100% of your income up to $23,000 for 2024. There are additional ways to fund a 401(k) in excess of this limit, but we will cover the Mega Backdoor Roth in a future piece.

3) What is an employer match?

Usually, there is no such thing as a free lunch. However, with employer matches, it is about as close as you can get. If you make $100,000 and your employer matches 4%, they will match you dollar for dollar up to $4,000.

It is very important to pay attention to the vesting schedule of the plan. It can be as friendly as immediate vesting (their contributions are automatically yours even if you leave) or as unfriendly as a 6-year graded vesting schedule. Essentially, you’d vest nothing in year 1 and 20% each year thereafter.

4) Is my money locked up forever?

When you reach the age of 59.5, you can access your money penalty-free. There are also a few different ways to access your money without being penalized prior to age 59.5. However, generally speaking, we want to avoid interrupting tax-advantaged compounding at all costs. In some cases, if a young professional were to need liquidity, some 401(k) plans allow for loans against your balance up to $50,000. This is also not necessarily something that we should look to, but in a time of need, it can be incredibly helpful.

5) What am I supposed to invest in?

I can’t go too in-depth on this front. Lots of 401(k)s offer target date funds, which will automatically change allocations as you age to a generally suitable risk tolerance.

One thing to pay attention to is the cost of the funds. 401(k) funds can range from less than .05% to over 1%. You want to ensure that your portfolio is cost-efficient and that you’re not overpaying if another cheaper fund is offered.

That’s our overview of 401(k) plan highlights. In my opinion, the 401(k) plan serves as one of THE MOST effective ways for people to save and invest. That is because of two things: automation and restriction. 401(k)s are the epitome of “set it and forget it.” You never see the money hit your checking account. This really allows people to psychologically detach from market fluctuations and stops them from trying to time the market.

Restriction is another aspect of what makes 401(k)s a great investment vehicle. Given there are restrictions and penalties associated with accessing the funds before age 59.5, you are less likely to liquidate, trade, or rebalance due to whatever bad news comes out in any given week. Usually, people just let the money compound, completely uninterrupted. Letting your money compound without interruption is the best way to invest over long periods of time.

If you haven’t started contributing to a 401(k), consider testing it out! If you are missing the employer match, you are potentially missing out on some of the “free-est” money you can get!

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Have a more specific question or want to get your finances in order? Feel free to reach out to [email protected] for a free consultation!