One of the key elements to successfully secure retirement for any individual is to start planning for it as soon as possible, many individuals commit the mistake of not taking enough advantage of the all the different tax incentives that a retirement plan can provide. If you were down the street and someone tells you that you could get your employer to give you an extra 3-5% of your income for free every month, would you say no to it?
Well, surprisingly this is one of the key elements over which the 401K plan is based and you would be amazed by the number of workers that either doesn’t take the right advantage or that pass on this opportunity entirely.
The idea of this article is to inform over the benefits that contribute to a 401K can have in someones life and net worth over time. While 401K are not considered investments by the IRS (savings), they act as investment devices that can allow an individual to benefit from the financial markets while saving.
Albert Einstein once said that the most powerful force in the universe was compound interest, and these words were not said to be taken lightly. Imagine contributing to an account $15,000 a year, to this number you would have to add the 100% match of your employer which will ultimately let you with $30,000 of savings a year. Considering that the stock market delivers on average a yearly return between 8-12% a year, we can conservatively say 10% that will result in $3,000 dollars of return a year for a total of $33,000 of savings a year from your initial $15,000.
Now imagine how your money can easily multiply over a long period of time where the interest generated and the earnings from the account will be reinvested year after year.
Keep in mind that while 401Ks are not the only option for retirement plans available in the US, they usually offer the best incentives and protection from the federal government. There are many different types of 401Ks and they usually offer certain specific benefits, in order to provide some color of the overall market these are the most common types of 401Ks available in the market in 2019:
Types of 401(K)s
Traditional 401Ks allow eligible individuals to defer a fraction of their pre-tax income for retirement. One of the major differentiators between an IRA and a 401K is that employers can contribute to these retirement accounts, matching the contributions of their employees by any given percentage.
It is important to mention that any contribution made by the employer can be subject to a vesting process or schedule, this means the employee will only receive the contribution in full after working for a set period of time. While this is not the rule for all plans, it is pretty common to see employers utilizing this in order to retain their personal.
Traditional 401Ks does not have a restriction in terms of a number of employees, making it a perfect opportunity by employers of all sizes and even business owners who are self-employed.
One of the major benefits of a traditional 401K is that they can be combined with other retirement plans such as an IRA. Like most retirement plans with a tax incentive, there is a contribution limit per year, for a traditional 401K employees cannot contribute more than $19,000.
A key point to mention is that the max limit for contributions is $19,000, but this only takes into consideration defer payments made by the employee and not the employer contribution or match. Overall limit including both employee and employer contributions are limited at $56,000, this leaves space for employers to contribute up to $37,000 per year.
One of the major pain points that any employer has to deal with when offering a 401K, are the non-discriminatory tests that they have to comply every year. These tests measures and compare how highly compensated employees and the rest of the other contributors utilize and take advantage of the companies 401K.
Any finding in these tests can result in expensive corrective measures, refunding contributions and a tonne of administrative bureaucracy that spooks the compliance department at any company.
The safe harbor 401K was created as an alternative that is exempt from these discriminatory tests, creating a neutral ground that protects employees and free employers from taking the tests and their procedures.
One of the key points needed for a plan to be safe harbor is that matching contributions are vested immediately, this means that employees gain access on the spot and it won’t be retained. This provides peace of mind for any employee as their retirement matching plan won’t be subject to working for an X period of time or even performance.
Here are some basic examples of contribution formulas:
- Basic matching: The company matches 100% for all employee contributions up to X%, plus an extra 50% match for contributions after the initial X percentage.
- Enhanced Matching: The company matches 100% for all employee contributions up to X% of their compensation (not exceed 6% of compensation)
- Non-elective contribution: This is a unique model that is only available for Safe Harbor plans, it consists of contributions made by the employer whether or not the employee contributes. In this case, the company will contribute a flat% of the employee’s compensation to a 401k plan.
Just like Traditional 401Ks, Safe Harbor plans can be combined with other retirements plans like IRAs. Please note that the max limit for contributions is $19,000, but this only takes into consideration defer payments made by the employee and not the employer contribution or match. Overall limit including both employee and employer contributions are limited at $56,000, this leaves space for employers to contribute up to $37,000 per year.
There is a lot of noise regarding why anyone would choose a simple plan over a traditional or over another retirement account like an IRA, in synthesis simple 401Ks are the result of the combination between a Traditional 401k and a Traditional IRA. This combination is very attractive as it offers characteristics from both types of accounts.
Just like Safe Harbor accounts, simple 401ks does not have to meet with the nondiscriminatory and top-heavy testing required by IRS compliance. Due to this, all contributions are fully and immediately vested, this allows individuals to gain access over any contribution made by its employer as long as they meet the requirements to receive such attribution and will not incur in any type of subjection from timing or performance.
A key characteristic of this plan is that loans can be taken, using the 401K as collateral for the loan. It is important to mention that for this type of loans the individual would be borrowing from their own money, and payments and interests will be paid to their own account. In case an individual fails to repay the loan, it will be considered as a withdrawn meaning that the individual would have to pay the taxes and any penalty as due.
Roth 401Ks allow individuals to access the same tax incentive as Roth individual retirement accounts (IRAs), effectively combining the best of both vehicles. As mentioned before, the major difference for this type of account will be its tax model. While in regular 401K taxes are paid in full once the money is withdrawn from the account, ROTH accounts tend to do the opposite, investing after-tax money. Under a Roth 401K, a $1 withdrawn is a $1 in the pocket as it’s taxes have already been paid.
It is important to mention that while there are several benefits associated with ROTH investment vehicles, these ones usually will depend on the tax bracket that the individual forecasts to be in the future. If your calculus suggests that you might find yourself under a bracket with a higher tax rate in the future then this type of plan will usually provide you with the best tax incentive. Otherwise, if you are planning on lowering your tax bracket, then you might wanna consider a traditional 401K as the tax paid in the future will be lower than paying upfront.
Another important characteristic of this type of plan is that withdraws are not as flexible as those for ROTH IRAs on which individuals can take out their contributions (not their earnings) whenever they want. ROTH 401K has a five-year rule for distributions to be considered as qualified and can be taken tax-free.
Please note that the max limit for contributions is $19,000, but this only takes into consideration defer payments made by the employee and not the employer contribution or match. Overall limit including both employee and employer contributions are limited at $56,000, this leaves space for employers to contribute up to $37,000 per year.
A solo 401K was specially designed for self-employees and entrepreneurs, allowing self-employed individuals to the same type of tax incentive and perks as any other employee. While the logic behind the plan is pretty much the same as a regular 401K, it is important to keep in mind that its structure is a bit more complicated to understand since individuals will play the role of both employees and employers against the IRS.
For instance, the contribution limit for a Solo 401K is $19,000 which is exactly the same as a traditional plan. But since you can act also as your own employer, you would be entitled to contribute up to 25% of your compensation, for a total combined contribution of up to $56,000 which is the standard limit between both employee and employer for traditional 401Ks.
One of the best benefits from this type of plan is that the IRS allows covering your spouse under this plan. This effectively doubles the amount you can contribute as a family, an extra $19,000 and a max contribution of up to $56,000.
Best 401k Providers
Unless you are a business and you are looking for a retirement plan for your employees or a self-employed individual, chances are you won’t be able to choose your 401K provider, having said so, these are the overall best providers available in 2019:
1. Vanguard Group
The vanguard group is a giant multinational with over $5.3 trillion in assets under management. The company is the largest provider of mutual funds in the world and the second ETF provider, only behind BlackRock’s iShares.
Ever since it was founded, the company has always preached for transparency in the financial markets, especially in the way individuals gain access to investment vehicles and the service they receive. One of the key focus points for the firm has been to deliver the best performance possible in the cheapest and most straightforward way. It is not uncommon to see mutual fund churning clients with unnecessary fees or simply by taking extra steps for execution.
While The Vanguard Group may not be the best option for anyone interested in actively managing their 401K, it is a great choice for hands-off investors looking to invest in a more macro way. With their vast range of mutual funds and ETF, you would gain access to every market imaginable in the world.
The Vanguard name has become a synonym with performance and even finance pedigree around the world, as a result, the company takes extra steps before hiring a portfolio manager and their collaborators. This ensures that only the best will be responsible for advising and managing any portfolio calibration.
When it comes to retirement you have to keep in mind that any investment is being done thinking about long term gains and not immediate profit, before selecting a 401K provider I actively recommend to lean towards any firm that has survived at least one market crash as in ’87 and ’08.
The reason for this is that these firms have proven to have the survival skills necessary in order to overcome markets meltdowns and still take afloat their customers. This is one of those moments in life where you simply need to hire experience.
2. Charles Schwab
Just like many what many other brokers have done in the past, Charles Schwab offers an opportunity for a fully inclusive investing experience, offering both brokerage and investment management services which include their retirement plans division.
Schwab’s investment model is pretty simple compared to other more technical options from this list, as it offers up to 20 different ETFs per portfolio. Effectively delivering a low level of correlation between funds and a desired level of diversification.
As a result of being a well-rounded brokerage house, the company has access to every asset publicly traded in the most important exchanges globally, which translate in immense opportunity to dress your portfolio with any type of asset based on your risk profile and tolerance.
Taking aside their already proven track record as a brokerage house and bank, Charles Schwab has become one of the most important names in the retirement industry and especially to those individuals who are self-employed or business owners. The firm has developed its own model designed for retail individuals, more tailor-made and with overall better service.
Please note that the company currently offers access to the major 401K types and also to other retirement vehicles like IRAs.
Fidelity is one of the biggest asset managers in the world, with current assets under management exceeding $2.46 trillion dollars as of January 2019. Over the years the company has continued expanding and diversifying into different areas besides their brokerage house, venturing into robo-advisor services to complement their retirement segment.
One of the key points of the model offered by Fidelity is the cheap access to mutual funds and the filter the company does to eliminate assets that are categorized as too risky based on every investor profile, maintaining the excellent risk levels at all time.
Since the platform is oriented for new investors and especially those looking to delegate the investment management to someone else, the firm has designed its own proprietary model that manages the portfolios following a hybrid system, combining both algorithms and financial advisors to restructure and rebalance portfolios when needed.
Even though the company offers 401K plans for nearly any type of company, in order to get best out of their experience it is needed to have at least 20 employees as part of the plan. Keep in mind that the retirement models offered by Fidelity are followed and used by both private and publicly owned companies that in some cases can reach the +100,000 collaborators.
Any investment might be a scary thing to do at first, but if you start your journey with a well sounded and reliable name like Fidelity, you won’t find yourself receiving bad surprises.
4. Merril Edge
Merril edge is the online brokerage unit of Merryl Lynch (owned by Bank of America since ’09). Even though many companies have remained cautious about using their service recently due to all the uncertainty from its restructuring, the firm is still a solid option for a full-service 401K.
The company has targeted a similar market to Charles Schwab, focusing on small companies and retail individuals looking to start their own retirement plan. In order to complement their overall business and to prove their stability, the company currently offer its users access to banking, lending, and wealth management services via Bank of America.
As a standalone firm, Merril delivers a cost-efficient service designed to provide with a broad range of investment options and a personalized service to each individual.
Just like with most 401K providers from this list, Merril offers access to the major financial markets and all investment vehicles publicly traded in major exchanges. This makes diversification way easier by allowing investors to efficiently spread their investments through regions, asset classes and sectors.
5. Wells Fargo
One of the biggest competitors for Merril is Wells Fargo, mostly because they both offer a pretty similar business model and the addition of gaining access to a major American Bank and their proprietary services.
Wells Fargo offers a whole combo of services which includes the regular 401K administration, trading services, investment Advice, and cash management, this lures most individuals who are interested in a whole experience having their investments and banking services under the same umbrella.
The firm is one of the largest diversified financial entities in the world, besides 401K management the company also offers access to wealth management services for which many sizable individuals prefer the firm over their major competitors.
It is important to keep in mind how big the firm really is, with the bank holding $2 trillion in assets under management and its investment advisory division holding another trillion it proves that Wells Fargo is a reputable institution with lots to offer.
Just like most of the other 401K providers, the company offers access to the major financial markets in the world and most of the publicly traded asset classes and investment vehicles.
Tips to max your 401k
One of the first things any individual interested in a retirement plan usually do is to straightaway sum their contributions and multiply them for the years until retirement, in many cases the result from this equation usually disappoint people as the number does not meet their expectations.
While it is important to forecast and have a clear view of the possible outcomes of a 401k based on your current contributions, investors should be aware that there are many other factors that will influence their returns both positively and negatively.
Here are some tips and strategies to successfully increase your retirement savings over time:
Take your time: One of the first things that I personally recommend individuals is to look at their 401K as a marathon and not a sprint. Success can’t be based on a single year of performance of the markets but on the overall growth over some decades.
As more Millenials become part of the working force, it’s been recorded a dramatic increase in the number of maxed 401Ks, this is an excellent example of individuals truly taking full advantage of their tax incentive accounts. Even though it is a good practice, it doesn’t mean that it is the only way for an individual to make their savings grow over time.
The main thing is to start thinking about your retirement as soon as possible, even if it means contributing to as little as you possibly can. As you move forward in your professional career you will be able to contribute more, just take the leap and start saving, after a while, it will become part of your lifestyle and will be easier.
Max the Match: If you are lucky enough to have an employer who offers to match your contribution, you should consider taking as much advantage as possible from this benefit. It is not every day that you can literally receive free money from a stranger and never the less from your employer. Over time, these matching benefits can boost your account dramatically.
Plan based on your current and future tax rates: The main differences between a regular type of 401K and a ROTH 401K is the tax incentive and how it is calculated. Individuals should at least have a notional of their current tax rates and based on their career expectancy or even their goals to visualize the rater under which they would be in the future. This is super important as it helps to determine if it would be smarter to pay taxes now or in the future.
If you are in a low tax rate and you are forecasting to be in a higher bracket by the time of your retirement, you would be better off investing in a ROTH 401K or ROTH IRA. Even though the money contributed will be taxed upfront, the income and earnings generated with the account will be completely tax-free.
On the opposite case, a traditional 401K would allow you to defer the taxes from your contributions until the time of retirements where taxes would be paid after the money is withdrawn of the account.
At the end of the day the idea of having a 401K is to take advantage of the tax incentive, and if you are going to do so why not doing it in the smartest way possible.
Automatize Contributions: While many employers will request every certain amount of months to confirm the amount that will be transferred from their paycheck into the 401K, some others will require manual confirmation. If it is possible the best option is to automatize the contribution, this will eliminate temptations of not contributing and spending the money somewhere else and will help with the overall habit of saving. If you are self-employed this is your best option as in most cases you won’t have anyone else to rely on but yourself.
Another thing point that it is important to try to automatize as much as possible is the future increases in your contributions. As a professional career increases and income grows it is important to continue updating the number of your contributions. Keep in mind that at the end of the day you want your retirement pension to be as close as possible to your last income or salary in order to sustain your lifestyle and necessities (or even improve them).
Avoid Early Withdrawals: No matter the individual there is always a certain level of uncertainty in life, things can change really fast and with no previous warning. Many individuals find themselves debating about doing an early withdrawal from their 401K plan, in many cases due to unexpected situations that require a cash solution.
While early withdrawals are an option for most 401k plans, individuals should be aware of the high penalties and rules of each specific retirement plan. The standard penalty is 10% of the cash taken from the account but some plans can charge up to 20% in order to deceive individuals from affecting their retirement balance.
If there is no other available option, one can go for a 401K loan instead of withdrawing from the account. This type of loan will lend the individual based on their account balance and will use their retirement account as collateral. Since you are technically lending to yourself, all fees and interests charged by the loan will go to your account directly. In case of default, the collateral will be executed but it is important to keep in mind that the same penalty for withdrawal will be charged.
In case of a loan in a ROTH 401K, there won’t be any extra taxes since the contributions were already taxed, otherwise, a traditional 401K would require the individual to pay the taxes for the loan based on their current tax bracket.
One of the most common questions many individuals ask before starting a 401K plan is about what would happen to their money if they change their employer, while there many different alternatives like moving the funds towards your new employer, the most practiced is to roll over the funds into an IRA type of account (traditional or Roth).
This is a great option in order to keep with the tax incentive gained with the 401K into another account without having to incur into extra expenses and tax surprises. Please be aware that if you choose to roll over a regular 401K into a ROTH IRA, you would have to cover and expense the taxes over the funds as in a regular Roth IRA. While there might several reasons for an individual to decide towards this type of practice, it is important to understand that in this case, one can end up owing the IRS up to 30% of the fund’s value for the conversion.
In order to achieve a smooth transition there several steps that need to be followed:
1. Decide between a ROTH or a Traditional IRA: As mentioned before, it is key to understand the goals and the tax cost before choosing one or the other. If you are not interested in incurring any upfront tax for the transition, you might be better suited with a Traditional IRA for which taxes will be paid at retirement age when the funds are withdrawn from the account.
2. Open a Roll Over IRA: There are several excellent options for brokers and providers that can manage your funds while invested in an IRA. It is important for any individual to do their own research before choosing any specific provider, the service is pretty much the same in a vast majority of them but the way funds are invested and the service package provided is where things can change real fast.
Just like a 401k, there are costs associated with the management of the account and the fees charged by brokers, please be aware that even though these fees may look small, they can compound over time and affect performance. At the end of the day, most of these types of retirement plans will last for decades so it is important to always look for discounts and cheap operational costs.
3. Solicit your 401K provider for a “Direct Rollover”: This simply means that the funds will be transferred directly from your 401K into your IRA provider without the necessity of them passing through your hands. This will ease the hassle of filling the required tax filings and will make the overall tax process easier.
It is always welcomed to avoid situations that could easily put you in a bad position with the IRS.
4. Develop an Investment plan for your funds: Must IRA providers will present several options for investors to start investing their capital. There are many different types of asset classes and investment vehicles available in the financial markets, but it is key for individuals to be aware of all the risks associated with each asset class.
Most IRA broker will offer their advisement services as part of their plan, take as much as an advantage as possible from these services as they will help improve your confidence as an investor.
With a 401K the importance is not how much you can contribute but actually how early and consistent you can do it. Many investors usually rush and try to contribute their max to later realize that they put themselves in a bad position from a liquidity standpoint. As with everything in life, it is important to find a balance for all situations, and especially between the necessities today and the needs one may encounter in the future as a retiree.
Investing in the financial markets has never been as easy and smooth as its nowadays, individuals should not let pass the opportunity to build a better future for themselves and their families.
Tax advantages will differ between 401K types but in synthesis, they offer individuals a loop to defer taxes on their savings until retirement. This effectively allows individuals to lower the amount of income they have to pay on taxes as the contributions are taken from the paycheck before any taxes.
The 401K model is incentivized to individuals as a complementary/alternative to a pension. Since they have public sponsored by the US government, there are many other incentives over time to lure individuals to start saving.
A key point to mention is that the max limit for contributions is $19,000, but this only takes into consideration defer payments made by the employee and not the employer contribution/match. Overall limit including both employee and employer contributions are capped at $56,000, this leaves space for employers to contribute up to $37,000 per year.
401Ks allow individuals to contribute higher than an IRA which is limited to only $6,000 a year.
The term vest refers to gaining access, control and ownership of the funds contributed by an employer as part of a 401K. Certain companies demand its employees to remain in the company for a defined period to receive full ownership over the funds, this is in part as a leveraged method utilized to reduce turnover rates in an organization.
Please review this point with your employer and 401K provider to understand the limitations in case you ever decided to change your employer. While vesting restrictions are fairly common, certain employers decide to offer a fully vested model after the contribution is made (this is a great benefit if your employer allows it), which means that employees gain full access and ownership over the funds.
While technically you can withdraw from your account at any moment, it is not until the age of 59 and a half that individuals can do so without incurring in any type of penalties and extra fees. Please be aware that are certain situations like medical bills or even disabilities that can lift the restrictions to a younger age.
One of the biggest differences between a 401k and an IRA besides the employer contributions is the fact that individuals can use their 401K as collateral and get loans based on their funds. With this lending model, an individual could receive a fast loan of a portion of their account balance and repay its interest and capital as it goes.
If an individual fails to repay the loan (defaults over the debt), the collateral in the account will cover the loan and for tax porpuses, it will be taken as if the individual did an early withdrawn which means that he/she will have to pay the taxes and penalties associated with it. While it represents a great benefit to have close to hand when there is no other alternative, individuals should be aware of the consequences of risking their future retirement in case they can’t repay.
There are different alternatives an individual can follow if they leave their current employer, the most common paths are:
- Roll the funds into an IRA
- Combine the funds into your new employer’s plan
- Leave the funds where they are and continue reinvesting them with that specific provider
- You can pay the penalty and the taxes and cash out the funds
While the most common option is to move the funds into an IRA, it will depend on each specific situation to address what is the best course of action to follow.
Yes, it is completely legal for an individual to own both 401Ks and IRAs at the same time and it is a fairly common practice.
This is a point for discussion where many people debate. While the IRA offers its own benefits like easier access to withdraws at any time (Roth), the 401K provides an overall better model which includes the benefit of an employer contribution and a higher max to contribute.
Since an investor is allowed to own both, I suggest planning your finances in a way that it will allow you to benefit and enjoy both types of accounts with no restriction.
This is a common question that it is a little bit to open. Individuals should understand their risk profile and their goals to determine which is the best type of 401K for them. While tax incentives are very similar between account types, the results will vary as they also take into consideration the tax rate and the bracket the individual is at the moment and also the forecast of where it could be in the future.
For most individuals, traditional IRAs and 401Ks are the way to go.
Just like with an IRA, some individuals are interested in actively managing their own positions and investments without the necessity of relying on a third-party advisor. While this has its own benefits like a cheaper overall cost, it can also result in disastrous results if you are not a sophisticated investor or simply if you don’t have the knowledge required.
Just like I mentioned above in question number 5, individuals should be aware of the risk associated with playing with their retirement. Unless you have the right experience and enough knowledge to sail the financial markets on your own, I suggest staying with an experienced financial advisor or asset manager.