401(k) = U R A-OK
Why this savings plan is a secret formula for security
Once you land your big girl/big boy job, it probably won’t be long before your employer encourages you to contribute to a 401(k). Some employers may automatically enroll you in one.
Though you probably know that a 401(k) has something to do with retirement savings, you may not know much else. Since a 401(k) should be more than a random acronym to you, here’s a rundown of this mysterious savings account.
What is a 401(k)?
A 401(k) is an employer-sponsored saving-for-retirement account. (If you work for public schools or other tax-exempt organizations, your employer might offer you a 403(b) savings-for-retirement account instead.)
Employees contribute a percentage of their pay to the account, and many employers provide a matching contribution. The money is then invested in mutual funds offered by the employer’s plan provider, where it grows tax-deferred until retirement.
Why were 401(k)s invented?
When Congress passed the Revenue Act of 1978, its Section 401(k) provided a tax-free way to defer compensation from bonuses and stock options. It wasn’t long before companies started using this provision to offer tax-advantaged savings accounts to their workers. (Sources)
Companies soon rallied around promoting 401(k)s to their employees as a way to save for retirement because it allowed them to move away from offering traditional pension plans. Under traditional pension plans, when employees retire, they receive a guaranteed set of monthly payments or a lump sum based on a percentage of their average salary and how many years they worked for the company.
Employers liked 401(k) plans because they were a less expensive way to offer retirement benefits to their employees. They could make defined contributions to employees’ 401(k) savings accounts, and they wouldn’t have to worry about investing well enough to cover the monthly payments their retired employees would have been due under a traditional pension plan.
What makes a 401(k) so magical?
The beauty of a 401(k) is that relatively small, regular contributions on your part can grow tax-deferred during the decades you have before you are ready to retire.
Once settled into my big girl job, I started contributing 4% of my salary to my 401(k). Though I knew I could afford the deduction from my paycheck every two weeks, it was a little hard at first because I could have easily taken that money and spent it on something for our house or put it into our travel fund. But I reminded myself I would appreciate having some money set aside for retirement someday.
Since the deduction came right out of my paycheck, it wasn’t long before I didn’t miss it anymore. When I left that job in 2000 and stopped making contributions to that 401(k), the money stayed on the job. Almost 25 years later, the $86 I set aside every paycheck has grown to $130,000, and it still has more room to grow before I retire.
Think of a 401(k) as a way to treat “Future-You” well. It automates your retirement savings, and your employer might kick in some money too. The sooner you start contributing even a small amount, the longer it has to compound on your behalf.
How many 20-somethings contribute to 401(k)s?
A recent Payroll Integrations report found that 36% of Gen Z workers aged 18 to 26 invested in a retirement plan, and more than half of Gen Z was contributing 11% or more of their salaries to their retirement plans.
Why should I worry about saving for retirement now when I'll need money for so many other things before I retire?
I get it. When you’re in your 20s, your financial priorities are more likely to be saving to buy a car or a house or paying off debt. Plus it takes money to establish a household of your own, and you may envision other financial responsibilities related to having a family looming on the nearer-term horizon.
As philosopher/songwriter Howard Jones cautioned, you shouldn’t try to live your life in one day. You won’t need all the money for all your goals at once. You won’t be able to pay for everything all at once either.
But if you try to consistently set aside a little bit for things on the longer-term horizon, the power of compounding will take over, and you’ll have a tidy sum of money set aside decades from now when you’re ready to retire.
Is my 401(k) like a piggy bank I can bust open if I need the money?
The funds in your 401(k) are all yours to keep. If you change jobs, the money goes with you (though sometimes the contributions from your employer may not be fully vested for a period of time). So, yes, it is kind of like a piggy bank.
However, because the primary purpose of a 401(k) is to fund your retirement, Uncle Sam wants to make sure that you don’t withdraw funds from it on a whim. If you take money out of your 401(k) before you are 59½, you will pay a 10% tax as an early withdrawal penalty in addition to owing ordinary income taxes on the money.
In certain hardship situations, you can withdraw from your 401(k) without penalty (This Nerdwallet article explains the calamities that qualify).
Many employers allow you to borrow from your 401(k) plan, which may be worth investigating if you’re trying to scrape together the money for a downpayment on a house since you’d end up paying the interest back to yourself. Just keep in mind that borrowing from your 401(k) isn’t without risks, as this Nerdwallet article spells out.
Is it true that having a 401(k) saves you money on your taxes?
In a traditional 401(k), your contributions are taken out of your pay without Uncle Sam taking a cut, so your money can grow tax-free. Taxes won’t be due on dividends or capital gains until you withdraw the funds after retirement.
So, yes, the money you contribute to a 401(k) in any given year is not subject to federal income tax, though generally you will still have to pay state and local income taxes on 401(k) contributions.
Social Security might be bankrupt when I retire, so why should I even bother with a 401(k)?
A gloomy outlook can be a tempting excuse for avoiding something you’re not eager to do right now, like setting money aside in a 401(k). In any case, if Social Security isn’t around when you retire, you’ll be glad to have a 401(k) at your disposal.
You’re not entirely wrong that the retirement landscape for Gen Z and Millennials looks less secure than it did for your grandparents, who might have been able to count on traditional pensions funded by their employers. This NYT article explains how and why funding retirement changed over the last 50 years. But while our current retirement system may leave something to be desired, you might as well make the best of the options available to you at present.
What happens to the money in my 401(k) if I change employers?
All that money still belongs to you. Your account can usually remain with the funds manager (Vanguard, Fidelity, etc.). Though you won’t be able to make any new contributions to that account, the money in it will continue to grow tax-deferred.
You may also be able to roll those funds into your new employer’s 401(k) plan or convert them into an IRA.
How much should I contribute to my 401(k)?
If your budget can afford it, you should contribute enough to collect the full amount of your employer’s matching contribution. For instance, if your employer matches 50% of the first 6% of your contributions, you would ideally aim to contribute 6% of your earnings to your 401(k).
If you are earning $40,000, this means you contribute $2,400 to your 401(k), and your employer would add another $1,200 to your 401(k) account. Since the $1,200 is essentially “free money” that’s there for the taking, you want to grab all of it if you can.
If I have extra money, should I put it into my 401(k)?
Even if you contribute beyond what your employer will match, a 401(k) still offers the benefits of deferring federal income tax on your investment earnings and capital gains. You can contribute a maximum of $23,000 to your 401(k) in 2024. The limit is likely to increase to $23,500 in 2025.
Nobody but you can assess whether your extra money should go into your 401(k).
You must carefully consider whether that money could be put to better use:
If you have credit card debt or student loan debt, it probably makes more sense to work on paying down that debt since every month you’re paying interest on the principal you owe.
If your priorities in the next few years include buying a car or a house, tucking those savings away in a more accessible savings or investment account might make sense.
My employer’s plan has so many options. How the hell do I pick which funds to invest in?
It’s easy to be overwhelmed by the variety of stock and bond fund options most 401(k) plans offer. The ideal blend of investments should be tailored to your age and risk tolerance. Your employer or the investment firm providing the 401(k) plan probably offers educational materials that detail what you should consider.
The easiest solution, especially if you just want to get started without doing a lot of in-depth research, is to choose a target-date fund. Target-date funds mix stocks, bonds, and other investments with an eye toward a particular retirement date. The general principle is that the portfolio carries more risk when its investors are young and is gradually rebalanced to become more conservative as its investors approach retirement.
So identify your expected retirement age–someone born in 1998 would likely pick a Target Date 2065 Fund–and the fund will automatically rebalance and age with you over time.
What can I do if my employer doesn’t offer a 401(k)?
If your employer doesn’t offer a 401(k) plan, you can contribute to an individual retirement account–commonly known as a traditional IRA. In 2024, individuals can contribute up to $7,000 and take a tax deduction in most cases. Many banks and investment firms offer traditional IRAs.
If you are self-employed, you can open a SEP-IRA, which allows you to contribute up to 20% of your net income (minus the self-employment tax) into the account.
Don’t let yourself get overwhelmed by 401(k)s. Start by learning the basics and contributing a minimal amount. You can always ramp things up over time. The key is just to get started.
Sociologist Karl Pillemer wondered, “Could we look at the oldest Americans as experts on how to live our lives? And could we tap that wisdom to help us make the most of our lifetimes?” He asked over a thousand older Americans to reflect on the right moves and the mistakes they made. His book 30 Lessons for Living provides concrete, practical advice about how to make the most of your life on everything from marriage to careers to money.
In the olden days, moms used to clip newspaper articles for their kids if they thought it was something they needed to know. I’m watching for things you might have missed that may be helpful to you.
This week’s clips:
Life Kit shared the secret to retiring with $800K. Read or listen here.
Sometimes your company’s 401(k) plan is less than ideal. The New York Times explains What to Do When Your 401(k) Leaves Something to Be Desired. Even if your company’s plan is good, it’s worth taking a peek at the hypothetical balances chart to see how habitual contributions can grow to a substantial sum over time.
Recently The New York Times’ Modern Love column celebrated its 20th anniversary. Its second most popular column of all time–“To Fall in Love With Anyone, Do This”-- tells the tale of what happened when two acquaintances asked each other three dozen personal questions aimed at encouraging mutual vulnerability, and thus intimacy. After the story ran, The NYT was flooded with messages from other readers crediting those questions for new relationships and marriages. Here are the 36 Questions that Lead to Love in case you want to experiment.
GenTwenty warns about four career mistakes to avoid in your 20s.