Retirement Accounts 101: The 401(k)

Antonio E Smith

Sep 28, 2021 • 4 min read

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Preparing for retirement can feel like a gargantuan task, considering the current state of most Americans. According to a 2019 study from Charles Schwab, 59% of Americans live paycheck to paycheck and 44% carry a credit card balance or struggle to keep up with bills/payments. This means that after all expenses are paid, many individual have nothing left over for saving and investing.

As current or future high income earners, it is our duty to ourselves and our families to manage our finances responsibly and fruitfully. Aside from more efficient spending, another major piece of the financial puzzle is to get your army of dollars working for you as early as possible for retirement. There will be several retirement accounts available to you throughout your working life to reap the benefits of compounding interest, the worlds 8th wonder and your Army of Dollar's greatest weapon.

Over the next few posts, I will do a brief overview of some of the retirement options available to us, specifically the 401/Roth K's as well as the Traditional/Roth IRA's. Check out my recent post on health savings accounts here. Having an understanding of your financial arsenal will give your army extra firepower to win your war against a broke retirement.

Brief History of 401k

The 401 K got its name from provision of the U.S. Internal Revenue Code section 401 in 1978 which allowed employees to avoid taxation on deferred income. Ted Benna, a retirement benefit consultant used this provision when designing a retirement plan for a client.

Although that client declined to use it because of concerns the provision would be repealed due to loss of tax revenue, it was eventually adopted by Benna's own company Johnson Co. (not Johnson and Johnson). Since its inception 40 years ago, funds held in a 401 K have grown to nearly 7 Trillion dollars.

What Does a 401 K Consist of?

A 401(k) is a retirement savings plan where a percentage of each paycheck is allocated to an investment account. The employer may sometimes match a portion or all of the employee contribution. The employee has a choice of a number of investment options which are typically mutual funds. Taxation differs depending on the type of account.

Taxation in Two Flavors

A traditional 401(k) is funded with pretax dollars, thereby lowering the taxable income. No taxes are due on capital gains until withdrawal or distribution. 403(b) is the non profit equivalent of the 401(k).

A Roth(k) on the other hand, is funded with the employee's after-tax income and contrarily, when the money is withdrawn during retirement, it is not subject to additional taxation.

If the employee retires after 59½, withdrawals will be taxed as ordinary income. Any withdrawals prior to this are subject to an additional 10% penalty.

Contribution Limits

By Age

As of 2020 and in 2021, the limits on employees under the age of 50 can contribute up to $19,500 per year and those over the age of 50 can contribute up to $26,000.

By Account

If the Roth option is offered, the employee can fund one or a mix of both, up to the annual limits on their tax-deductible contributions.

After Tax Contributions

If the employer makes contributions, or if the employee makes additional after-tax contributions to their traditional 401(k), the total employee/employer contribution for 2021 is capped at $58,000 for employees under 50 years of age. For those 50 and over, the limit is $64,500 ( including the $6,500 catch-up contribution).

After Tax contributions can be used as part of the "Mega Backdoor Roth Strategy that will be discussed in the near future.

Which One Do I Choose?

One question the saver/investor may ask is which one is better? The answer depends on a few factors such as age/retirement time horizon, outlook on future taxation, and strategy.

Factors Favoring the Traditional 401(k)

Savers close to retirement may find the immediate tax break more beneficial than the possibility of tax-free withdrawals in the future.
If saver expects to be in a lower bracket in retirement, benefits from tax savings on pre-tax contributions may outweigh future taxation upon distribution
Saver plans to do Roth conversion strategy later.

Factors Favoring Roth(k)

Saver expects to be in a higher bracket in retirement or will have higher tax obligations in the future as a result of political factors.
Saver is younger and farther out from retirement with expectations that future income will be significantly higher.
Saver is close to retirement and 401(k) distributions will increase taxable income, resulting in higher medicare premiums and social security taxes.

Summary

401(k) pre- tax contributions and growth are not taxed, but distributions are taxed upon withdrawal.
Roth(k) contributions are post tax but growth and future withdrawals are not taxed.
Age, retirement time horizon, outlook on future taxation, and strategies such as Roth conversions are all factors to consider when deciding on which account to fund.