What is a 401(k)? My Financial Mistake #2, Expanded

I wanted to devote this post to my Financial Mistake #2. You can check out my other four financial mistakes in this post.

I was a fresh new veterinary school graduate in my mid-20’s. I was nearly $120,000 in debt from my student loans. I had zero knowledge about retirement or retirement planning. This is not so uncommon.

My boss was an older man on the cusp of retiring. I remember him taking me aside one day, asking if I wanted to make retirement contributions and if I understood how vesting worked.

Uh, no and no.

He then went on to explain how vesting works. He explained how he would match a percentage of my retirement contributions, and the longer I stayed, the more I would keep of his match. I was so clueless when it came to saving for retirement that I didn’t even understand the idea of a match. I actually thought that I wouldn’t be able to keep any of MY contributions with me unless I stayed a certain number of years.

(People- this is embarrassing. But it’s true. For you newbies that don’t quite get it, keep reading on and I’ll explain it in more detail.)

Thinking that I wouldn’t be able to keep any of my contributions (since I wasn’t likely to stay at this practice for more than a couple of years), it made the idea of saving for retirement even less desirable. So I just told him that I wasn’t interested and went about the rest of my day.

I bet he was shaking his head in disbelief that I would turn down a) a chance to contribute to a retirement account and b) an employer match. Looking back, I am also shaking my head in disbelief that I was so naive.

But this entire exchange is actually not surprising at all. Not once did I have a conversation with anyone about retirement until the day my boss brought up the subject. My family never brought it up, my friends certainly never brought it up, and I don’t recall ever learning about it in any sort of educational setting. It’s not a subject where young people actively seek out information (Professor….can you PLEASE teach us about retirement??? Pretty please?? We’ve been waiting all semester!). The idea of retirement is too fuzzy and not relatable to those in their 20’s. It just goes to show that financial literacy fails to occur at so many levels.

So for those of you that have yet to save for retirement, I hope I can convince you why you should start saving now.

WHAT ARE EMPLOYER-SPONSORED RETIREMENT PLANS?

Since I hightailed it out of that retirement conversation with my boss, I don’t even know what type of plan he was offering. But for the purpose of this post, let’s say that it was a 401(k) plan, since that’s the type that is typically associated with retirement planning. I will discuss other types of retirement plans in a separate post.

A 401(k) is a type of defined contribution plan. This means that you, the employee, makes the decision to contribute to the retirement plan. You are the one responsible for managing this money.

This differs from a typical pension, which is a defined benefit plan. With a pension, the employee is typically automatically enrolled. It is up to the employer to manage this money for you. These types of plans are becoming more uncommon because they are more expensive for the employer.

For the 401(k), once you decide to contribute, you need to decide the amount.  For tax year 2020, the limit is $19,500. If you are 50 or over, you can make an additional $6,500 in contributions to pad your retirement savings, which is usually referred to as a “catch-up” contribution.

WHAT DOES “VESTING” MEAN?

Your employer may decide to match your contributions, up to either a certain percentage point or a set amount, to your retirement account. However, just because they match you doesn’t mean that the money is automatically yours. They may decide to have a vesting schedule, where you only get to keep a certain portion of the match depending on how long you’ve stayed with the employer.

For example, they may decide that you can keep 25% of their match if you stay for 1 year, then 50% of the match if you stay for 2 years, etc. To be 100% vested means that you’ve put in the appropriate amount of time to get 100% of their match.

In regards to YOUR contributions, you are 100% vested from the get-go. This is the part that had confused me with my former boss.

WHEN YOU TAKE THE MONEY OUT

In a perfect world, you would just leave the money alone and not touch it until you’re 59.5 (why they chose this age, I do not know). What if you’re wanting to take your money out early? Well, there will be a penalty for that. If you withdraw that money before age 59.5, then there is an extra 10% penalty tax for an early withdrawal. So for example, if you’re wanting to withdraw $50,000, then $5,000 gets taken right off the top. Plus, you’ll get taxed at your ordinary income tax rate. Using this calculator and some average tax percentages, one estimate of your net withdrawal would be only $28,500.  You’re only getting to pocket 57% of the withdrawal. Ouch.

There are some situations where you won’t get the penalty. You can find a list of rules regarding early withdrawal exceptions here.

There are some plans that will allow you to take out a loan from your 401(k). This is not a good idea on many levels. Be the type of person that has an emergency fund– much easier to use this emergency fund than it is to borrow from your 401(k).

If you leave that money alone, there is a point where you will have to start taking money out in the form of a required minimum distribution (RMD). These RMD’s kick in starting at age 70.5.

Yes, apparently half birthdays are a thing in retirement planning. Strange, but true.

WHY CONTRIBUTE AT ALL?

Well, I’ve written a post detailing how retirement planning is falling more onto the individual, so it’s becoming YOUR responsibility to learn about this. No one is going to hold your hand and make sure you start putting some money away.

Below are the compelling reasons why it’s good to start saving money in a 401(k).

1. Compounding: Had someone made it clear that saving for retirement sooner rather than later was the best bet due to the magic of compounding, I would like to believe that the numbers alone would have caught my eye and my attention, even if for a short while. It’s really remarkable how the numbers can grow exponentially, and having time on your side works in your favor.
2. Taxes: Another incentive would have been the tax advantages of contributing to retirement. The contributions are pre-tax, meaning that it lowers your taxable income. If your income is $100,000, and you contribute nothing to your retirement account, you would be taxed on the full $100,000. According to this calculator, your federal taxes would come out to $15,410. However, if your income is $100,000 and you contribute $10,000 to your 401(k), you would be taxed on $90,000. The calculated federal income tax would be $13,100. That’s a difference of $2,310, which ends up in your pocket to do as you wish. Yes, you had to have $10,000 taken out of your salary, but hopefully you will have an employer match, and your contributions grow tax-free. You will not be taxed on the dividends and capital gains…basically on any of the growth that your account experiences. The taxes come into play at the end, when you start to take money out of the account.
3. Match, a.k.a. Free Money: Did someone say free?? Well, not much in life is free, but this comes pretty close. The rules regarding how much they will match will vary widely depending on the employer. Say you’re making $100,000,  and your employer says that they will match 100% of your contributions up to 3%. You decide you will contribute up to the match, which would be $3,000.  You put in $3k, your employer puts in $3k, and now you have a cool $6k in your retirement account because of the match. You doubled your account value, even though you only directly contributed half the amount. A good rule of thumb is to contribute up to the match, at the very least. Bonus points if you contribute beyond the match up to the limit.

HOW TO INVEST?

It’s one thing to open up an account. It’s another thing to actually figure out how to invest your money.

When you make a contribution, it will sit as cash in your account. If you let it just sit there, it’s just as good as keeping it under your mattress. It will not grow, and it will actually lose value over time due to inflation. You have to take the next step of actually investing that money so that it can grow.

Do you need a ton of investing knowledge to choose some investments? No- most of these retirement plans will offer a target date retirement fund, otherwise known as a lifestyle fund. These are mutual funds that will contain a mix of stocks and bonds, and you can choose the fund that matches your risk tolerance and projected retirement date. This is a popular option because it keeps things simple- you only pick one fund and you’re done.

However, for those that like to have more control over their investments, it may not have the asset allocation you’re looking for, or it may not match your investing style. Your choice will ultimately depend on you, your investing plan, and your retirement goals. If you want to get started on learning about investing, click here. And don’t get so bogged down in the details- learn enough to feel comfortable, and understand that you can always tweak your plans in the future as you learn more about investing.

CONCLUSION

Saving for retirement: one of those tasks that always seem to fill people with dread. I say, let it fill you with excitement and possibility! Knowing that you have that nest egg delivers peace of mind. People have all sorts of dreams about what they want to do when they retire: travel, spend more time with family, pursue hobbies and passions, etc. I hope that you’re making space for all those important things NOW to the best of your ability, and retirement will be a continuation of doing things that you love to do, but with less of a time constraint.

Also, understand that even maxing out your 401(k) may not be enough to get you to your retirement number. Run your numbers and aim to have an overall financial plan that will get you to where you want to go.

So go ahead and look into your employer-sponsored retirement options now if you haven’t done so already!

Do you consider yourself financially savvy with retirement planning? Please share any tips or tricks when it comes to saving for retirement in the comments!