Wednesday, August 8, 2012

From zero to 401k

Ok so as you probably know, a 401k doesn't actually stand for $401,000. It's a type of retirement savings account named after subsection 401(k) of some U.S. legalese [1]. So what's all the buzz behind it and why does it matter?

Road to retirement

A 401(k) account is provided through your employer. The idea behind it is that you put some money in every year and lock the sum away until you retire. By imposing some rather strict guidelines and fees on early withdrawals, a 401(k) account offers two very worthwhile benefits.

Employer match

Many employers will often match your contribution to your 401(k). This means if you put \( X \) amount of dollars into the account, your employer will contribute an additional \( cX \) dollars, where \( c \) is some pre-agreed upon percentage in your benefits contract. Some companies will provide a dollar for dollar match while others will match 50% or some other percentage. In addition, there is typically some additional fine print that limits the amount they contribute to some percentage of your total pay (e.g. up to 6% of your total salary).

However, in spite of the limitations, it is ultimately free money. No matter what additional investment options you may consider, you cannot hope to compete with a 50-100% return.

Tax Benefits

Not all employers will match your contribution, but that doesn't necessarily mean you shouldn't invest in a 401(k). The second benefit is saving money on your taxes. There are two kinds of 401(k) accounts: a traditional account and a Roth account, the difference being when taxes are collected.

Traditional 401(k)

In a traditional 401(k), contributions are made on a pre-tax basis. This means that contributions are made before income taxes are collected, and you are only taxed on the remaining income.

Suppose you are single and made $100,000 this year, putting yourself in the 28% tax bracket [2]. Normally, you would be paying $28,000 in taxes that year. However, if you had contributed $10,000 towards your 401(k), your taxable income for that year becomes $90,000, or only $25,200 in taxes. The catch is that you must pay taxes on the $10,000 when you withdraw the money in retirement.

Why is this potentially beneficial? The key assumption is that when you retire, your retirement income (amount of money you receive through such withdrawals, pensions, etc) might be less than what you are making currently. If your income in retirement is only $35,000 per year, that will put you in the 15% tax bracket and the money you withdraw will be taxed at the 15% rate, not the 28%. This means you pay $1,500 upon withdrawal, a net gain of 13%.

Roth 401(k)

In a Roth 401(k), everything works in reverse: your contributions are made on a post-tax basis. You pay your income taxes as usual, and then you put money into your retirement account. The benefit of this approach is that you won't ever have to pay taxes on that money ever again. As you can see, the Roth 401(k) benefits those who are already in a low income tax bracket and will likely be a higher bracket in retirement.

Let's consider another case study. Suppose you made $35,000 this year, taxed at a rate of 15%, leaving you with $29,750. If you put $5,000 towards your Roth 401(k), this will give you with $5,000 in retirement, regardless of what tax bracket you may be in the future.

Other Benefits

Money put into retirement is also money invested. The money is typically put into various investments like stocks, bonds, and mutual funds, where it will grow over time. You do not have to choose between putting money into a retirement account and investing it.

So What?

If you compound the tax benefits, employer match, and overall market return, you end up with a sizable gain on your retirement cash. The only cost is that you cannot withdraw the money until you retire (or else pay a hefty fee). If you have income to spare, it is almost universally worth it to put it into a retirement account.

In the first case study, your $10,000 will be matched by your employer, giving $20,000. Over 30 years at a 10% yearly market return, this yields \( 20000(1+0.10)^{30}=348988 \). At a 15% retirement tax rate, this leaves you with $296,640. If you had invested this money in the stock market yourself, you would first pay a 28% tax, no employer match, subject yourself to much greater market risk, and end up with an expectation of $125,635, less than half of our previous result.

The Roth 401(k) tells a similar story.

On the issue of choosing between a traditional 401(k) and a Roth 401(k), optimizing your expected returns can be rather complicated. But as a simple rule, if you're in a low tax bracket (e.g. students, recent graduates, etc), go with the Roth. If you're in a high bracket, go with the traditional account. If you're somewhere in the middle, the difference is negligible compared to the big picture (I will work through the math in a future post).

The Fine Print

A few important points:
  • You can only withdraw without penalty after the age of 59 1/2
  • Withdrawing early will incur a 10% fee
  • In certain cases like buying a house, you can take funds from your retirement account without fees
  • There is a yearly contribution limit (inflation adjusted and depends on age)



Obligatory Disclaimer

The author is not a financial adviser, tax accountant, or lawyer and disclaims any and all liability for the contents of this blog. The information reflects the author's personal research and experience, which may contain errata.