Make the Most of Your 401k With Free Money.
Are You Leaving Free Money on the Table?
When I started my first real job out of college, some of the best advice I received about money was simple. A colleague advised, “Contribute to your retirement 401k plan enough to get the company match.”
So without knowing a wit about what I was doing, I started contributing each and every paycheck. It was automatic, and I learned to live without it. And like clockwork, the company gave me half of what I contributed as well.
It was free money!! Do you have this benefit available to you, and are you taking advantage of it? Confused as to why your company would just give you money on top of your paycheck? Read on to learn more . . .
So How does it Work?
Your 401k is essentially an employer sponsored savings plan to be used once you reach retirement age. You can contribute up to $18,500 per year if you are under 50. If you are over 50 you can add an additional $6000 per year for a maximum of $24500. These rules are set by the IRS, not by your employer.
Now, not every employer offers a 401k saving plan. Some employers offer different plans, so whatever options you have, be sure to check it out. Read through their information, and make sure you understand it before you contribute.
Where does the free money come in?
Your contributions are deducted from your paycheck before taxes are calculated making the money in this account tax-advantaged (unless you have a ROTH option – which is super cool). Meaning you don’t pay taxes on the money you contribute. (A ROTH is different, and probably a different post altogether.)
You save in taxes (at least initially – you’ll pay taxes later) because you saved money. That’s pretty cool – right. Not exactly free, because as I mentioned above, you will pay taxes when you withdraw the money in retirement.
But wait – there’s more. In most cases, not only do you contribute into this account, but your employer does too!
That’s right, when you contribute 8% of your paycheck for example, your employer may contribute 4%. These percentages vary by employer. Some may contribute up to 3%. Others may match your contribution dollar for dollar up to a set limit. In any case, any employer contribution is free money.
Any employer contribution is essentially free money!
Contribute the amount you need to max out your employer’s contribution. In my case, I contributed 7%, and my employer contributed 3.5% immediately.
I got a 50% return right away!! Where else can you get that kind of interest rate instantly and guaranteed?
What’s the catch?
In some cases, you must be vested in the plan to keep the employer contributions. In other words, if you leave the company or plan before you are vested, you will lose the employer contributions. You won’t lose your money, just theirs.
You also don’t have direct access to this money. It’s for retirement after-all. If you do want to use this money before retirement, there are some options though.
What are My Withdraw Options?
You can withdraw money at any time, but you will pay taxes (at a rate determined by your taxable income), and you will pay a 10% penalty. Ouch!!
So if you withdraw $10,000 to buy a car, you will only end up with close to $6500 in your pocket. Please don’t do this!!! Your sweet $10k ride just turned into a modest $6k daily driver. Again – Not a good plan!
Disability, Hardship, First-time Home-buyer, Education Expenses
You can withdraw money for any one of the scenarios listed above. You will still pay taxes, but not the penalty. Depending on your situation, this may or may not apply to you. This is not a good option either, because you are robbing your future self of growth on the money you withdraw. Especially when you can plan for most of the situations above and save up other money instead – like an emergency fund.
A third option is to borrow against your account balance. This is called a 401k loan. You will only be able to borrow a portion of your total. And then you will have to start paying it back with interest.
Those who argue that this is ok will say that you are paying yourself back and not a bank. Plus you are giving interest to yourself. What’s wrong with that? They argue that leveraging your 401k can be profitable. The math may work out, but personal finance rarely works out exactly the way the math dictates. Keep It Simple Stupid!!
But let’s think about it. If you don’t take a loan, your contributions (and your employer’s) are regularly invested and continue to grow. – Good.
But when you take a loan, your contributions are going towards replacing the money you took out – with interest. So unless you increase your contributions by the amount of the loan payment, you are losing a lot of money that can be growing. Most people who want to take a 401k loan are not in the position to increase their contributions by this much otherwise they would not have taken out the loan in the first place.
Also, the interest you pay yourself is intended to recoup some of the opportunity cost, but it doesn’t make up for the reduced contributions. Unless you increase them yourself as I mentioned before, you’re still losing out.
Another stipulation of a 401k loan that most don’t think about is: If you leave the company, your remaining 401k loan balance is due in full. Otherwise it’s considered a withdraw. And we’ve already established that this a bad idea.
Bottomline: 401k loans are also not a good plan.
Roth conversion ladders and SEPP 72(t)
These are more complicated for the purposes of this discussion. I may write more about them in the future, but for now if you are interested, check out this article from the “madfientist”.
I tell you this so that you know your options, and that you do have access to this money if you need it. Just try not to need it. You will end up losing money if you decide you need this money before retirement.
Best practice: Contribute the maximum amount to receive the entire employer match. And then leave it alone! Don’t touch it until retirement, and just watch it grow.
It’s kinda like watching grass grow, or like watching paint dry – boring at first. But before you know it, you’ll be a 401k millionaire. It takes time, but it can happen. At least that’s what I’m hoping . . .
And the employer match is free money, so take it!
Do you have a employer sponsored retirement plan that you are taking advantage of?
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