Tuesday, January 10, 2023

The 401(k)

This is the retirement account most people are familiar with.  401(k) accounts are available through your employer.  Contributions come out of your paycheck before taxes are withheld, which allows for greater contributions.  Growth within the account is also tax-free.  However, you must pay personal income tax when you withdraw money from the 401(k).

Contribution Limits

You are allowed to contribute a maximum of $19,500 per year.  Employers are allowed to contribute up to $57,000 per year on your behalf -- so any "match" your company provides as a perk goes in a separate bucket and does not count against the limit that you yourself can contribute.


Many employers offer a match on your contributions.  The amount and limit of the match is decided by your employer.  As a common example, a company might match 50% of your contributions, up to a maximum of 6% of your salary.  Thus, if your salary is $100,000 annually, then the first $6,000 that you contribute will be matched with up to $3,000 by your employer.  You would still be allowed to contribute more (up to the personal contribution limit), but your employer would not match those additional contributions.

Also, be careful not to fall into the Undermatching Trap.

Tax Benefits

401(k) accounts are funded with pre-tax dollars (you make deposits using money withheld from your paycheck).

401(k) accounts grow tax-free.

401(k) accounts are taxed as income when you withdraw money.  If you make the unfortunate mistake of withdrawing before age 59-and-a-half, you'll have to pay an additional 10% penalty on top of the taxes!  (Do not ever do this if you can avoid it)

Recommended Providers

Since a 401(k) is provided by your employer, you don't get to choose who manages your account.

Recommended Investments

Since a 401(k) is provided by your employer, you may have a limited selection of investments.  If you're lucky, you'll be able to choose an index fund or a target date fund.  Pay attention to the expense ratios -- you want to stay under 0.5%.  The expense ratio is the fee that you pay for investing in the fund, so the higher the expense ratio, the lower your growth.

When I start a new job, what 401(k) choices should I make?

If don't already have retirement savings, then the only choice that matters is the choice to get started.  Start right away. How much you save isn't nearly as important as how soon you start.

When I leave my job, what should I do with the 401(k)?

When you change employers, one good option is to do a rollover of your 401(k) into a Traditional IRA account.  Then, when you eventually leave your next employer, you can rollover that money as well. And the next, and the next.  Not only will keeping the money in an IRA usually give you better investment options, but it will also keep you from having too many retirement accounts left hanging around from previous jobs.