Thanks for coming back to Planning for your Purpose; Telos Financial’s blog where I discuss different topics related to financial planning. CERTIFIED FINANCIAL PLANNER™ professional Dennis LaVoy is Plymouth, Michigan’s financial advisor for high income young professionals, Millennials, Xennials, and Generation X serving clients throughout the Ann Arbor and Detroit area, and across the country.
The purpose of the blog is to introduce financial planning concepts and questions I receive from clients that I believe are important. I want to start discussions about that will educate, benefit, and improve your financial life. Ultimately, to help you focus on your telos!
If you are or have been employed by a company, other than small operations or start ups, you probably have or have had access to a 401k plan at some point. If you haven’t, or if you’ve only worked for small firms that didn’t offer retirement plans, you’ve probably heard of these type of plans. 401k savings accounts are the largest financial asset for most families and now is a very common benefit.
While 401(k) plans are the most common type of work retirement plan, there are other plans that are similar. 403(b) plans are the almost identical, but are for non profits. SIMPLE IRAs are also similar, but have several key differences you should be aware of if you participate in one.
What is a 401k?
A 401k is a retirement savings account that is sponsored by your employer and is classified as a tax qualified account. That means the money in the account has special tax treatment, which in most cases means it’s pre tax money, or it was not subjected to federal or state income taxes when you earned it.
401ks are special in that they must be sponsored by an employer and money can only be added to your account by salary deferral or by an employer (with very few exceptions).
Tax Treatment of Savings
Pre Tax or Traditional
I mentioned that most savings to 401k accounts is classified as pretax. That is, when you defer your compensation to add it to a 401k plan, you don’t pay federal or state income tax. What does that mean? It means you get more money into the account (because you didn’t have a portion go to taxes) now, so you’ll have more saved to grow and compound on itself. It also means, when you do withdraw the money in the future, it will be taxed as ordinary income at that time.
Many plans offer a Roth savings option. There’s no requirement to do this and it doesn’t (that I’ve ever seen) cost the employer more to have Roth option. So, many do it as a bonus benefit to employees. Roth 401ks work very similarly to Roth IRAs, especially in tax treatment. The Roth savings in a 401k account is after tax dollars going in, but when you withdraw funds in the future, it is not taxed. You may want to read that again. . .
To illustrate the benefit of this, let’s say you put $125 into a 401k account as Roth savings and assume it grows to $1,000 after 30 years (that’s the equivalent of getting 7.2% per year net return for 30 years), you would have $875 of growth and (as long as you follow the qualified withdrawal rules) you would never have to pay any tax on that gain. That’s $875 of tax free money you earned.
Now, I’m not saying Roth savings are the best for everyone, but they have some wonderful benefits.
The third possibility for tax treatment of 401k savings is after tax money. This is the rarest type of 401k savings and consists of money that is in a traditional 401k account, but is different in that it’s already had income tax withdrawn from it. The growth however is all treated as pretax money. Confused? Yep, it’s not logically straightforward.
As with everything in finance, there are many pros and cons and different uses for this type of savings. It may benefit you to utilize it if it suits your situation and it may not. It will definitely benefit you to be aware of it.
Other benefits to 401k plans are they may have lower costs than a stand alone investment account. There are two reasons for that, one is because many employers will pick up some of the costs associate with the accounts and the other is economies of scale. Your account is part of a larger plan, so it’s easier for an investment company to provide the services associated and that is passed along. Of course, there are some additional costs with these plans, so maybe it costs more with what your employer is paying.
If your company offers a 401k plan, you will receive an annual notice about how the plan works. Much of it will be in legalese and will be disclosures, but there are parts that are important. You should understand how you can save to it and what tax qualifications for the account are available. Know if there’s a match. Understand how long you need to stay with the employer for your match to vest. Learn what investment options are available. The point is, you have a right to a document that lays all this information out and more.
Should I save to my 401k?
That’s hard to say. Probably, but it this is a question that’s specific to you. Ideally, you’d review your total savings plan within the scope of a holistic financial plan and determine whether or not saving to a 401k is a good fit. You should also review the costs, investment options, tax ramifications, and any other relevant information to help inform your decision.
That said, if your employer offers a match and you have been or plan to be employed there long enough for the match to vest, it’s free money. It’s a pretty safe rule to say if your employer offers a match that you should be saving to it at least to take advantage of the match. Again, it’s free money in your retirement savings account.
401k accounts are a widely used account type. There are rules that guide all 401k plans and there may be differences between every plan, it pays to know these rules.
Telos Financial is a Michigan’s financial advisor for Millennials, Xennials Generation Xers, & young professionals. It is a fee based, holistic financial planning firm located in Plymouth, Michigan serving young professionals and families. Dennis LaVoy, CFP®, CLU® founded Telos in his tenth year as an advisor and uses his experience, knowledge, and expertise to help families and individuals in Ann Arbor, Detroit, surrounding areas, and across the country achieve their financial objectives.
The views expressed are my own opinions and do not apply to every situation. Your situation may vary so make sure to consult a professional for advice prior to making any decisions.