What You Don’t Know About your 401K, and Why You Need to Know About it.
Senior Home Loan Advisor
Caitlin Chen
Published on January 12, 2021

What You Don’t Know About your 401K, and Why You Need to Know About it.

There could be many reasons why you may avoid investing in a 401(k). The ones I’ve heard most often are: I can’t afford to contribute, the market is too high or I’m still young. Whatever reason you’ve had for not investing, maybe it’s time to set them aside and start now. The easiest way for me to start a new process is to gain a better understanding of it which is why I’ve updated this post.

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Over the years, I’ve had quite a few questions about what exactly a 401K is and why it’s beneficial to contribute to it.

Understanding Your 401K

A 401K is a retirement plan sponsored by your employer. The contributions made is considered tax-deductible because you can save a portion of your paycheck before taxes are taken out, which reduces the amount of taxes you pay.

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The earnings from your savings are tax-deferred until the money is withdrawn from the account, given you’re at least 59 ½ years old, at which time you will pay ordinary income taxes. However, if you must withdraw the funds before age 59 ½, then there may be a 10% IRS penalty in addition to the ordinary income tax. However, there are some situations where you will not incur a penalty from early distribution but will still be taxed nevertheless. Below are some scenarios where you may not incur the 10% penalty.

  • Permanent disability of the participant.
  • Qualified 1st time home buyer for owner occupied property (taken out as a loan).
  • Qualified military reservists called to active duty.
  • Rollover of your 401K to another qualified IRA plan for previous employers. You will not be allowed to rollover your 401K for an employer you currently work for unless you’re 59 1/2 or over.

Why Save for Retirement?

As the aging population continues to grow older and living longer, we are more likely to spend a longer period in retirement. Below are some statistical data.

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  • 1970: Men spent an average of 11.3 years in retirement
    Women spent an average of 15 years in retirement
  • 1990: Men spent an average of 15.5 years in retirement
    Women spent an average of 19.1 years in retirement
  • 2016: Men spent an average of 17.2 years in retirement
    Women spent an average of 20.6 years in retirement

In addition to the need to save more as we live longer, we also must account for year-over-year inflation. The most current rate of inflation is 1.5% for the 12 months ended in March 2020 as published in the U.S. Inflation calculator

Example of the Impact of Pre-Tax Savings

Regular Savings 401K Savings Plan
Employee’s earnings $50,000.00 $50,000.00
before tax savings of 10% $0.00 $5,000.00
Taxable earnings $50,000.00 $45,000.00
Federal tax of 22% (assumed) -$11,000.00 (22% X $50,000) -$9,900.00 (22% X $45,000)
Social Security / Medicare tax @ 7.65% -$3,825.00 (7.65% X $50,000) -$3,825.00 (7.65% X $50,000)
After tax savings of 10% -$5,000.00 $0.00
Employee’s net take home pay $30,175.00 $31,275.00 extra $1,100 in take home pay with 401K

Contribution Limits

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In 2020, the maximum amount you can contribute to your 401(k) is $19,500. However, for individuals 50 or older, you can make a catch up contribution of an additional $6,500 per year.

Benefits of a 401(k) Match

A major benefit of a 401(k) is the employer match. Although not all employers have a matching program, a large portion of employers do so make sure you ask your HR Department.

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Now let’s say that your employer has a matching program of 3%, then you will have an additional $1,500 in your 401(k) savings by the end of the year based on an annual income of $50,000, plus an extra $1,100 in take-home pay (see example above).

If you’re lucky enough to have an employer that participates in matching, make sure you save enough to capture the full value of the 401(k) match.

Taking a Loan from your 401(k)

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One aspect of a 401(k) not many people know about is the ability to take out a loan from it if you have a need such as an emergency, paying off unmanageable debt or even for purchasing a home. IRS allows allows you to borrow up to 50% of your current balance on the condition your firm allows it. Although contributions to your 401(k) are with pre-tax dollars, payroll deductions for repayment of the loan will be with after-tax dollars.

The downside of the tax implication is that when distributions are taken at retirement, you end up paying taxes on it again so you’ll be paying double the tax.

Final Thoughts

The most important aspect of having access to a 401(k) is to always take advantage of it since it’s invested with pre-tax dollars. If your firm offers a company match, make sure to maximize it. After all, it’s like free money, why not?

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Senior Home Loan Advisor
Caitlin Chen Senior Home Loan Advisor
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(213) 248-1230