A 401k account in the United States is a tax-qualified, defined-contribution pension account. I used a couple of words there that don’t generally come up in polite conversation. So I’ll take a moment to define them. A tax-qualified plan is a fancy way of saying that the account qualifies for deferred or reduced tax liability from the IRS. A defined-contribution plan is one in which an amount or percentage is set aside by the company for each of its employees. Defined-contribution differs from defined-benefit as money is set aside individually for each participant. With a defined-benefit plan an actuary gets involved to make sure the company is adequately funding the pension for all of the participants.
What’s in a Name
The account gets its name from the subsection of the Internal Revenue Code under which it is defined. You may have guessed this by now but the subsection is 401k. 401k plans are generally implemented at companies. Similar but slightly different plans called 403b are generally offered at non-profit institutions. And 457b plans are generally available for government employees. If the government agency in question has a 401k plan it was grandfathered in and established before May 1986. All of these accounts 401k, 403b, and 457b are tax-qualified, defined-contribution accounts. For the purposes of the rest of this article when I say 401k substitute in the name of the plan that applies to you.
Even with the different names the underlying purpose in the same. For the institution to provide a benefit to its employees that will allow it to attract and retain the employees it needs to perform its function. The benefit is that an individual employee can defer taxes by contributing to the account. As of 2016 the elective deferral limit is $18,000 with the annual defined contribution limit being $53,000. For most folks with access to a 401k account that means $18,000 in income can be saved into the account and paying taxes on the income can be deferred until the money is withdrawn in retirement. Even with this being pre-tax FICA is still withheld so the 7.65% to cover social security and medicare is still withheld. The only way to avoid FICA taxes is with an HSA account.
Why defer taxes
A 401k account allows participants to squirrel away compensation on a pretax basis. This is a valuable feature as our tax system is mostly progressive. That is to say in general the more you earn the more you owe in taxes. It makes sense then to defer taxes on as much income as possible when you are earning a lot. When withdrawing from the account in retirement if the amount withdrawn is less than what you were earning earlier in life the tax paid on the withdrawals should be lower than what would have otherwise been paid. To add to the benefit the pre-tax money was allowed to compound in the account. This could very well mean that there was an extra 25% in the account to grow and compound on itself than there would have been if an after tax account had been used.
Lets look at two simple examples. One in which a full $10,000 is saved each year and allowed to compound on itself. And another in which $10,000 minus 25% taxes is saved and allowed to compound for ten years. The first example with owe income taxes at the time the money is withdrawn from the account. While the second example will only owe capital gains taxes on the amount.
Pre-Tax Saving at $10,000 a year:
For those with itchy spreadsheet fingers I used the function =FV(3/100,year,-10000,0,1) in LibreOffice Calc to generate this data set. The $10,000 was saved at the start of each year.
Post-Tax Saving at $10,000 minus 25% taxes.
This time I used =FV(3/100,year,-7500,0,1) to generate this data set. In this second example the 25% taxes were paid up front so out of the $10,000 available each year to save only $7,500 made it to the investment account. Now both $118,077.96 and $88,558.47 are tidy sums. But, the former has nearly $20,000 more in it than the post tax. When withdrawing from the after tax account if you stay under the 25% income tax bracket the long term capital gains tax in 0%. So the after tax account can be tapped in a tax efficient manner. However, the pretax account if you only withdraw enough from it to stay under the 25% income tax bracket the withdrawals from it are paid at 10% for the first bit and 15% for the rest. When that income was earned it would have been taxed at a higher rate than that. Overall the tax advantaged account allowed more to be saved and after taxes on the distributions more to be withdrawn.
How much can be Deferred
For 2016 up to $18,000 elective deferral can be made to a 401k account. Then an additional $5,500 can be stashed in a traditional IRA. Then $3,350 can be tucked back in an HSA account for an individual or $6,650 for a family. That means an individual can defer $26,850 in income pretax every year. If you are over 50 catch-up contributions are allowed allowing an individual to save $6,000 more in a 401k and an additional $1,000 in an IRA. At age 55 and older the HSA allows a catch-up of $1,000. An individual aged 55 with a family HDHP and associated HSA account could save 38,150 annually on a pre-tax basis.
The amounts that can be saved in the 401k and IRA are indexed to inflation and rise over time. If you are reading this a few years after publication go check out the IRS’s website and see what the contribution limits are. There is also a phase out on the IRA being tax deductible if your income exceeds certain limits. Again, go check the IRS’s website for details as the limits are determined based on filing status and are updated over time to reflect inflation.
What can a 401k be invested in
The company that administers the 401k plan for your company will provide a menu of mutual funds that the contributions to the account can be invested in. Some plan administrators offer an fine array of low cost broad market index funds that are in the best interest of the investors. Others see this as a chance to slip some high fees funds in. Check the prospectuses closely and avoid funds with high expense ratios like the plague. Some of the funds that end up in 401k plan investment menus border on fiduciary irresponsibility on the part of the plan administrator. Keep your eyes open and make sure you know what you are paying for.
When picking funds in a 401k refer to your investor policy statement to make sure the asset allocation of your entire portfolio including the funds held in the 401k account match your strategy.