What Is A 401(k)?

Corporate retirement plans are valuable tools for employees. In addition to personal savings and Social Security, a corporate retirement plan can help you retire in style, but what the heck is a 401(k) plan?

A 401(k) plan is a savings plan offered by your employer, allowing you to contribute a percentage of your pay to your retirement account. Your employer may also match your contribution, but more on that later. Let's review some critical components of a 401(k) plan.

Contributions

The IRS allows you to contribute $22,500 of your pay to your plan; if you're fifty or over, you can deposit another $7,500 for a total of $30,000. How much should you contribute? My recommendation is to contribute the maximum amount allowed by the IRS. If you can't contribute the full amount, then aim for 10%. If 10% is too much, then match your employer's match. If that is too high, contribute what you can because something is always better than nothing.

Profit Sharing

The 401(k) plan can include a profit-sharing match. However, from all sources, the maximum contribution to your plan is $66,000 or $73,500 with the catchup provision. Let's say you're fifty-five, earn $200,000 annually, and contribute 20% of your pay, and your employer matches 5% and offers a 10% profit-sharing match. Your regular contribution is $22,500, the catchup provision is $7,500, the match is $10,000, and the profit-sharing contribution is $20,000 for a total of $60,000.

Vesting

You are always 100% vested with your contribution because it's your money, but your employer may restrict the employer match or profit-sharing contribution. For example, a six-year vesting schedule means that 20% of your employer contribution becomes yours every year. Then after six years, the entire balance belongs to you, regardless if you remain employed or move to a new company.

Traditional or Roth

Most 401(k) plans allow for traditional or Roth contributions. If you choose the traditional route, your contributions are pre-tax, and a Roth contribution allows for after tax-contributions, regardless of your income. If you're a high-income earner, consider a Roth 401(k), so your funds will grow tax-free.

SPD

Each 401(k) plan comes equipped with a summary plan description (SPD), a resource guide for your plan. The SPD highlights the plan's name, benefits description, vesting schedules, fees, investment funds, etc. Your HR manager or plan administrator should deliver it when you enroll.

Investments

Your plan fund lineup can include mutual, exchange-traded, and target-date funds. The lineup allows you to select funds and build your portfolio based on your risk tolerance. If you don't want to make your own portfolio, you can choose a target-date fund based on your retirement year. For example, if you're retiring in 2055, select the 2055 fund. The 2055 fund will get more conservative as you get closer to your retirement date. The investment process is automatic if you choose funds from the pre-selected list, meaning you do not need to invest the money every pay period.

Brokerage Window

A brokerage window allows you to select investments beyond the pre-selected fund lineup provided by your employer. You can buy individual stocks, bonds, mutual funds, and ETFs if your plan has a window. You may also trade options but tread lightly. If you select this option, you must make the investments each pay period; it's not automatic. Several years ago, a client called because his 401(k) was invested in the money market account, and he was upset because the market was marching higher. I informed him he selected the brokerage account and had to invest the money himself, which he did not want to do, so we moved his funds back to the traditional side of his plan.

Loans

Most 401(k) plans permit loans, allowing you to borrow 50% of your vested balance to a maximum of $50,000. You can use the funds to purchase a home, pay for college, or cover medical expenses. Leaving your employer before you repay the loan is a distribution, subject to taxes and penalties. If you're under age 59.5, the tax penalty is 10%.

Retirement

When you retire, you can leave your assets in the plan or roll them over to an IRA. If you keep your funds in the corporate account, you still must take your required minimum distribution at age 73, similar to an IRA.

Start

A 401(k) plan is an excellent way to create generational wealth, especially if your employer offers a generous match. Congratulations if you're contributing the maximum to your plan, but if not, start today because the sooner you start, the sooner you can finish!

If you're just starting out in the workforce, the very best thing you can do for yourself is to get started in your workplace retirement plan. Contribute enough to grab any matching dollars your employer is offering (aka the last free money on earth). ~ Jean Chatzky, Financial Journalist and Media Personality

January 31, 2023

Bill Parrott, CFP®, is the President and CEO of Parrott Wealth Management in Austin, Texas. Parrott Wealth Management is a fee-only, fiduciary, registered investment advisor firm. Our goal is to remove complexity, confusion, and worry from the investment and financial planning process so our clients can pursue a life of purpose. Our firm does not have an asset or fee minimum, and we work with anybody who needs financial help regardless of age, income, or asset level. PWM's custodian is TD Ameritrade, and our annual fee starts at .5% of your assets and drops depending on your asset level.

Note: Investments are not guaranteed and do involve risk. Your returns may differ from those posted in this blog. PWM is not a tax advisor, nor do we give tax advice. Please consult your tax advisor for items that are specific to your situation. Options involve risk and aren't suitable for every investor.