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Finance glossary

What is a 401k?

Shanna Hall
8 Min

Definition of a 401k

A 401k plan is a type of retirement savings account offered through employers. There are two types of 401k plans: traditional and Roth. A traditional 401k plan allows employees to contribute pre-tax dollars toward investment. The funds within the account are not taxable until withdrawn.

On the contrary, a Roth 401k involves contributions made with post-tax dollars. However, any growth within the account is tax-free, creating tax-free withdrawals. Regardless of your contribution type, your employer might make matching contributions to your retirement account.

It’s important to differentiate between a Roth 401k and a Roth IRA. An individual retirement account, known as IRA, is another type of retirement savings account. One of the primary differences is that IRAs are not employer-sponsored. This type of account is created by you and only includes post-tax contributions.

Example: traditional 401k vs Roth 401k

Let’s look at an example. Mary has a gross paycheck of $1,000. Her tax rate is 20% and she contributes 10% of her pay to a traditional 401k. Mary’s contribution of $100 is subtracted before taxes are paid, resulting in a net taxable income of $900. On this paycheck, Mary will pay $180 in taxes and have a net check of $720.

Now, let’s assume that Mary is making a 10% Roth 401k contribution. Her taxable pay would remain at $1,000, resulting in taxes of $200. Then, her 10% contribution would be subtracted to create a net check of $700. Remember, Roth contributions are calculated based on your gross income, not your net income after taxes.

By using a traditional 401k contribution, Mary is taking home more money each pay period but will also be subject to taxable distributions. Evaluating your tentative tax situation now and in the future can help you determine which type of retirement plan is right for you.

Foundation: understanding the basics of a 401k account

Retirement accounts are designed to help you retire comfortably, saving a portion of your paycheck each month. Let’s go through some of the basics of 401k accounts, including your contributions, employer contributions and tax advantages.

401k contributions

401ks are offered and managed by employers. However, the IRS determines the amount you can contribute each year. For the 2024 tax year, employees can contribute up to $23,000 to either a Roth 401k or a traditional 401k.

In addition, employees over the age of 50 can make an additional $7,000 in catch-up contributions, bringing your total to $30,000. Workplace retirement plans are beneficial to automate your retirement savings, as the money is immediately withdrawn before you receive your paycheck.

In an employer-sponsored retirement plan, it is more difficult to select your investments, as your plan might only offer specific mutual funds and stock options. Individual retirement accounts, like Roth IRAs, give you complete control over your investment allocation, while workplace retirement plans might only have a handful of investment avenues.

Employer matching contributions

Employers also can match your contributions. Most employers offer some type of matching contribution, such as 3% of your gross wages up to a certain dollar limit. Employers can also make discretionary contributions, which is a set dollar amount allocated to each employee.

Like individual contributions, the IRS also sets limits on how much employers are able to contribute each year. For the 2024 tax year, the total of employer and employee contributions cannot exceed $69,000.

This means if you put in $20,000, your employer can only put in another $49,000. Employer limits won’t generally be applicable unless you are an owner or executive. Nevertheless, employer contributions are one of the main advantages of holding a W-2 job, as it can help you build your nest egg quicker with ‘free’ money contributed on your behalf.

Tax advantages

Depending on your situation, you can make retirement account contributions on a pre-tax or a post-tax basis. The above example demonstrated that pre-tax contributions lower your income now, while post-tax contributions lower your income in the future.

If you are in a high tax bracket now, it can make more sense to make pre-tax contributions. On the flip side, if your tax bracket is low, postponing the tax benefits until retirement can be more beneficial.

In many cases, employees choose to have a mix of both traditional 401k and Roth 401k contributions. However, you can always utilize Roth IRAs for post-tax contributions as well. Working with a qualified accountant is the best way to leverage the tax advantages of 401k plans.

Benefits: how people leverage investment options within your 401(k)

Contributions to your 401k are invested into the stock market and other assets to grow your portfolio. In many cases, you can choose which investments your 401k portfolio holds. Remember, individual retirement accounts require you to select your own investments, while an employer-sponsored 401k has a team selecting your investment options and managing your portfolio.

Common types of investment options

When you sign up for your 401k, your employer or plan manager will give you a list of your investment offerings. There can be different types of investment classes, like bonds, mutual funds, ETFs, and stocks.

One of the most popular types of investment options is known as target date funds. Instead of changing your risk allocation as you approach retirement, your target date fund will automatically adjust its holdings.

For example, Vanguard might have a target date fund called “Vanguard 2050.” The investment allocation in this fund will be geared towards workers who are retiring in 2050. You can either choose to put all of your contributions in a target date fund or add a mix of other investments.

Most plan providers are willing to meet with you to help you select your options at no cost to you. If you are confused about which investments you should choose, take advantage of this resource.

How to diversify your portfolio

Portfolio diversification is a term used to describe spreading out your assets between multiple classes, industries, and sectors. Portfolio diversification helps reduce the risk of financial losses if the market were to take a turn.

For example, if you have 100% of your investments in technology, what happens if the sector has a slow year? You will lose significant portfolio value. Now, what happens if you only had 20% of your 401k in technology? Your portfolio wouldn’t sustain as big of a price fluctuation, helping you preserve your value.

The easiest way to complete portfolio diversification is to choose investments in different classes and industries. This could be allocating 10% of your portfolio to bonds, 30% to ETFs, and 50% to blue chip stocks. Working with a finance professional is the best way to ensure you are properly spreading out your funds.

Evaluating the performance of your investments

The performance of your investments is heavily dependent on the market. In 2022, the stock market experienced a 24% loss. This means if you had $100 invested at the beginning of 2022, your balance would only be $76 at the end of the year.

However, in 2023, the market rebounded, earning 26% in 2023. Taking your ending balance of $76 in 2022, at the end of 2023, you would have $96. Historically, the stock market has averaged a 10% return over the past 100 years.

Despite the performance of your investments falling in 2022, you earned back a majority of your income by the end of 2023. This makes it important to avoid pulling investments out during poor performing years. The market will rebound and recoup your investment.

If you are unhappy with your investment performance, you can always change your allocation by talking with your 401k plan administrator. Be sure you are making informed decisions and not relying on fear of market downturns.  

Adjusting your allocation when nearing retirement

401k plans are designed to fit your needs. When you are far away from retirement, you might choose to invest in riskier investments. This is because you have more time to recoup your investment if you were to sustain a loss.

However, as you near retirement, you don’t want to be taking on high levels of risk. What happens if your portfolio loses 20% of its value and you need to pull funds out? You are stuck with the loss.

As your retirement outlook changes, you need to adjust your retirement savings account accordingly. Maybe you decide to put more of your contributions towards bonds in your 40s and 50s compared to startup funds in your 20s and 30s. Find an investment allocation that matches your situation.

Strategies: strategies for maximizing investment returns

Although no one can time the market, there are strategies you can implement to maximize your investment returns.

Dollar-cost averaging

Dollar-cost averaging is the process of purchasing investments in regular intervals, regardless of the price. Let’s say you contribute $100 per month to your 401k. You would purchase the same mutual fund each month, regardless of if the price is $50 or $100.

The goal behind dollar-cost averaging is that your cost basis in the assets will even out. For example, you’ll buy mutual funds above and below market price. Dollar-cost averaging is a great strategy to build up your 401k funds, as you aren’t trying to time the market.

Compound interest

Compound interest is one of the most important components of building your retirement account. The money earned within your retirement savings plan will continue to generate income. For example, if you invest $100 in the market with an average return of 10%, you will have $110 in your account at the end of the year, earning $10.

However, after the end of the next year, you will have $121, earning $11. Even though you didn’t invest any more money, your yearly return is increasing because your earnings are now generating income. This is the power of compound interest.

Investment fees

Investment fees directly impact your retirement savings growth. If your fees are too high, you won’t be able to fully leverage compound interest and maximize your returns. When it comes to your retirement savings plan through your employer, you most likely have little say in how the plan is managed and the fees charged.

You can choose investments with low fees. Mutual funds have some of the highest management fees, while certain stocks and real estate investment funds have fees of less than 1%. When choosing your investments, keep the fees in mind.

Investment strategies

Market fluctuations can happen and impact the growth of your retirement savings account. It’s important that you don’t make any rash decisions when the market is fluctuating, like selling off your investments. This will most likely result in a loss.

Instead, keep contributing money to your 401k and utilize dollar-cost averaging. This will help you maintain portfolio growth even during times of loss. If you are still concerned about the market or your portfolio, reach out to an investment advisor.

Oversight: managing your 401(k)

Your 401k plan needs to be managed as your life circumstances and retirement goals change. For example, if you get married or have a child, you will need to update your beneficiaries. Regularly review and rebalance your portfolio. In addition, don’t try to time the market. Instead, make regular and consistent contributions to see your balance grow.

Retirement laws also frequently change. As you near retirement age, be sure you are up to date on when you need to take distributions. Furthermore, the contribution limits are adjusted each year. If you plan on maxing out your contributions, understand how much you can set aside each year and make sure your payroll provider is on the same page.

In summary

  • Roth 401k contributions are made on a post-tax basis, while traditional 401k contributions are pre-tax.
  • Roth IRAs are not offered through an employer like Roth 401ks.
  • Contributing to your retirement account is important, even during periods of market uncertainty.
  • If you are still unsure where to start with your 401k, reach out to your human resources department or your 401k plan provider.

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