Types of Retirement Accounts: 401k

Retirement. It’s something that most of us don’t think we need to worry about until we get older. Retirement is also something that most of us don’t think we can worry about right now. After all, we have student loans, expensive healthcare costs, rising housing prices, kid’s college, aging parents, and a host of other financial worries that usually push the idea of retirement to the back of our mind. Additionally, retirement can be overwhelming. Most people have no idea what to invest in, how the investing process works, what tax implications our decisions may have, and most of all; how much money do you need to retire. So let’s check out the 401k.

While all of these questions will be answered in future articles, this article will start on the ground floor with the question: What are the different types of retirement plans? There are several different types of retirement plans and in this article, we will be addressing #3, the 401k. These articles will give you an idea of what to look for when deciding on how to save for retirement and what type(s) of retirement accounts to save in.

Types of Retirement Plans

1. Traditional IRA
2. Roth IRA
3. 401(k) (this article)
4. 403(b)
5. SIMPLE IRA
6. Simplified Employee Pension (SEP)
7. Salary Reduction Simplified Employee Pension Plan (SARSEP)
8. Payroll Deduction IRA
9. Profit-Sharing Plan
10. Defined Benefit Plan
11. Money Purchase Plan
12. Employee Stock Ownership Plan (ESOP)
13. Thrift Savings Plan (TSP)
14. 457 Plan

IMPORTANT: READ THIS BEFORE CONTINUING

Before we get into the types of retirement accounts, it is important to make one key distinction. A retirement account, itself, is not an investment. If you say something to the extent of, “My 401k hasn’t done very well this past year and I’m thinking of picking a different one” you would be making an incorrect statement.

Think of it like this: There are 14 different types of retirement accounts (we will discuss the other 13 in different articles). Each one of those retirement accounts should be thought of as a cooking pot. If you cook something in that pot and you don’t like what it tastes like, you don’t dump the contents into another pot and hope that it tastes better. You change the ingredients of that pot to something else. Now think of the ingredients as different investment products (stocks, bonds, cash, mutual funds, and/or a host of other products/ingredients).To get the taste you want, you change the ingredients, not the pot. You may be wondering, what ingredients do I put into my pot? That is a fair question, but you cannot answer that question until you figure out what pot is best for you. Now buckle up and find out what the 14 different types of retirement accounts (pots) you have at your disposal.

Credit: Nicholas Gras: https://unsplash.com/@armgd

(3) 401(k)

A 401k is the largest wealth-building asset that we have in the United States. Most people have access to one at their job (59%). However, not many people actually take advantage of it (32%). By not investing in a 401k, you are not only most likely leaving free money on the table, but you are also putting your financial future at risk. In fact, in the United States, we will be facing a severe retirement crisis soon. There are far too many people who don’t contribute to a 401k (or any other form of retirement or savings for that matter). To make matters worse, more and more people who are retiring do not have enough savings to last throughout retirement. And to make matters worse still, 21% of adults have NOTHING saved for retirement. This is a problem that I aim to help you with. I don’t want anyone (but certainly not my readers) to fall into this category. I want to give you the tools and knowledge to understand what a 401k is and how it will help you retire in comfort and peace. In order to do this, let’s first define and understand what a 401k actually is. 

The term “401k” refers to the 401st section of the Internal Revenue Code, subsection K. Think of it as referring to a Bible verse: John 3:16 refers to the book of John, chapter 3, verse 16.

If you work for a public company you most likely have a 401k that is offered to you as part of your employee benefit package. But if you work for a small company, non-profit employer, are a government employee, or are self-employed you will not have one available. Click on the link that fits your situation to find out how your particular retirement plan works. You can also ask your human resources counterpart in your organization what you have available.

Before I get too much into detail, I cannot stress enough, the importance of investing into a 401k. You CANNOT rely solely on Social Security. The maximum Social Security benefit is $46,740 (if you retired in 2021 at 70 years old and less if you retired earlier and/or younger). Also, the debate rages as if Social Security will be around for a long time. I’m not here to argue one side or the other of that debate. But I will tell you that if you want to retire, you have to be the one to save and make it happen. You should not rely on the government, an inheritance, or winning the lottery to be able to retire. If you get any one or all of those things, cool. But you should live your life with the understanding that in order to do retire, you have to start putting money into your retirement account right now. Soap box: over.

As I stated before, the 401k is the largest wealth-building asset that most people have. This is for several reasons:

1. It is the most widely offered retirement vehicle (59% of people have it available).
2. Most of the time, employers will match some amount that you put into a 401k.
3. It can be easily transferred into another 401k or an IRA if you leave the company.
4. There are usually several different investment options in a 401k.
5. You contribute to a 401k as a payroll deduction (just like your taxes) which makes it more convenient to contribute to.

In short: a 401k is an investment vehicle offered through employers to their employees. A 401k allows money to be put in and grows with the intention of using it for retirement at a later date. Within the 401k you can invest in a number of different options (stocks, bonds, mutual funds, etc.). The money that you have in your 401k will grow with time until you want to retire, at which time you will have enough to live on. Remember the example of the cooking pot. The 401k is the cooking pot and the various investments (stocks, bonds, mutual funds, cash, etc) that you put in it are the ingredients. There are two main types of 401ks: the Traditional 401k and the Roth 401k. Let’s dive into the Traditional 401k first.

(3a) Traditional 401(k)

An traditional 401k is the most common form of retirement account. It is money that has been put into an account to be used for one’s retirement savings. A 401k is referred to as an “employer sponsored retirement account”. This is because it is offered through the employer (hence, they sponsor it). 

Here’s how it works: At his job, Bobby goes to your human resources person and tells the HR person that he doesn’t want to be broke when he retires and wants to put money into a traditional 401k. The HR person tells Bobby that he is making an excellent choice and asks him how much he wants to put into his traditional 401k each paycheck. (For the sake of this example) Bobby tells the HR person 10% of his paycheck. They discuss the proper investments to put into his 401k. He fills out the necessary paperwork and then leaves. Bobby is happy and goes back to his job as a college football waterboy in Louisiana. 

A couple of weeks later, Bobby gets paid his regular paycheck of $2,000 (before taxes). He sees that he has had some things taken out of his paycheck including federal taxes, FICA taxes, health insurance, and now (for the first time) traditional 401k contributions of $200 (10% of his pay). This happens every paycheck for the rest of the time that Bobby works at his job. When Bobby retires some years later, he has that money to help support his lifestyle of living in a cabin in the swamplands of Louisiana. 

It works as simply as that. However, there are some stipulations of  traditional 401ks that are important to be aware of. You don’t have to memorize these, but just know that they exist.

1. Investments: Within a traditional 401k you can have many different investments such as:

1. Stocks
2. Bonds
3. Mutual funds
4. Unit investment trusts
5. Government securities (Treasury bills, treasury notes, and treasury bonds)
6. US government-issued gold and silver coins. 

If you don’t know what all of these different terms mean, that is perfectly fine. Just know that you can have nearly all investment within a  traditional 401k.

But, there are a few items that cannot be in a traditional 401k. 401ks cannot have:

1. Antiques
2. Gems
3. Rare coins
4. Works of art
5. Life insurance contracts: This is because life insurance contracts are not securities (investments).
6. Municipal bonds: This is because putting a municipal bond in a 401k would negate the tax free status of the municipal bond.

Antiques, gems, rare coins, and works of art cannot be included in traditional 401ks because these items do not have a solid market value. Meaning: I might be willing to pay $50,000 for a painting, but you may be willing to only pay $3,000 for the same painting. It is too difficult to find an agreeable market value.

2. Contribution Limits (as of 2021): You can contribute up to $19,500 to a traditional 401k if you are 49 years old or younger. If you are 50 years old or older, you can contribute an additional $6,500 for a grand total of $26,000. This is known as the “catch-up” contribution. It is meant to help people who are a little bit older put more money in their retirement account because they have less time before retirement. The catch-up contribution can start to be made the year that you turn 50. So if your birthday is in September, you can contribute the full $26,000 starting in January of that year even though you are only 49.

Age	Maximum Contribution
Less than 50	$19,500
50 (the year you turn 50)	$26,000
Older than 50	$26,000

3. Income Restrictions (as of 2021): The rules regarding income restrictions for contributing to a traditional 401k are a little hard to follow. The important thing to know is that no matter what, you can contribute up to $19,500 ($26,000 if you are 50 or older) to your traditional 401k not including any match. The maximum eligible income for contributions to a 401k is $290,000. The income limit is best explained from this example from The Motley Fool:

For example, if you’re paid $400,000 and your employer also offers a 5% match on your 401k salary deferrals, you can contribute $19,500 in 2021. Your employer match will be only $14,500, though, instead of the full $19,500. That’s because it’s limited by the $290,000 compensation limit for 2021. Even though 5% of $400,000 is $20,000, 5% of $290,000 is only $14,500.

This leads us to the next important consideration of  traditional 401ks.

4. Employer Matching (as of 2021): Most of the time, employers will match some amount that you put into a 401k. This is the BEST reason to invest in your 401k. That’s because it is free money! My dad always had a saying: “If it’s free, it’s for me.” You should take this to heart. For example, if you make $4,000/month and you deposit just 5% of your paycheck into your 401k and your employer matches 5%, you have effectively contributed 10% of your pay to your retirement. That is a great deal! People want to brag about investing and getting a 10, 15, or maybe even a 20% return. If you contribute at least the employer match into your 401k you have already achieved a 100% rate of return! You can’t get that anywhere else.

The importance of taking advantage of a 401k match cannot be understated. According to Chris Hogan and Ramsey Solutions, it is the number one way that people become millionaires.

Let’s talk about Bobby from earlier. Let’s assume that Bobby makes the average US household income of $68,000, is 31 years old, and will retire at 67. Here are some examples of how much he would have in his retirement account with various levels of employer-matching 401k contributions.

Cont. %	Cont. $	Match %	Match $	Growth %	Total W/O Match	Total W/ Match
3%	$2,040	3%	$2,040	3%	$315,183	$630,366
4%	$2,720	4%	$2,720	4%	$420,250	$840,500
5%	$3,400	5%	$3,400	5%	$525,299	$1,050,597
6%	$4,080	6%	$4,080	6%	$630,366	$1,260,731

As you can see, contributing at least up to the match is extremely important. It can double your money.

5. Early Withdrawal (as of 2021): As stated in other articles about the different retirement accounts, you should never withdraw money out of a retirement account before you have reached age 59 ½. The money is there for you to retire with, not buy a new boat or go on a vacation. If you take money out of a 401k before you have reached age 59 ½, you will have to pay ordinary income taxes PLUS a 10% penalty on the monies that you withdraw.  For example, if you are single and make $50,000/year and want to withdraw $10,000 from a traditional IRA, you will be taxed 22% ($2,200) + 10% penalty ($1,000). You will only come home with $6,800 (even though you withdrew $10,000) after taxes and the penalty. However, if you decide to withdraw money out of a 401k before 59 ½, you can do so under two different umbrellas set by the IRS.

1. Hardship Withdrawals: The IRS allows for someone to take funds out of their 401k prematurely if they can demonstrate a hardship or fall under the “safe harbor” guidelines set forth by the IRS. This is outside the scope of this article but  can be found here.
2. 401k Loans: The IRS allows for loans to be taken out on a 401k account that have several different rules and regulations. The bounds in which someone can take out a 401k loan and the bounds of repayment of said loan also fall outside the scope of this article but can be found here.

6. Required Minimum Distributions (as of 2021): Traditional 401ks have required minimum distributions (RMDs) once you reach the age of 72. This means that the IRS will require that you take out a small amount of the money you have in your traditional 401k account each month. What you do with this money is up to you. Some people spend it, some save it, some give it away, and some just reinvest it. The calculation for RMDs is outside the scope of this article, but it is important to know that you will be forced to withdraw some amount of money after you reach 72.

This concludes all of the knowledge necessary to understand how a traditional 401k works. However, you may be asking yourself, “I have a Roth 401k offered at my job. What is that?” That’s a great question and let’s answer it.

(3b) Roth 401(k)

First, let me start out by saying that a Roth 401(k) is one of my favorite overall retirement accounts.The one thing to remember that differentiates Roth 401(k)s from other investment products is that with a Roth 401(k), you pay taxes on the seed, not the harvest. This will make more sense soon.

A Roth IRA and Roth 401(k) is named after the US Congressman, William Roth, who helped sponsor this version of an IRA that became a law in 1998.

A Roth 401(k) works very similarly to a traditional 401(k) with one key difference. The difference being that when you put money into a Roth 401(k), it is done after-tax. Let me explain how this works. But in order to properly explain this you must remember Rule #1.

Rule #1: Whenever you make money, you MUST pay taxes on that money SOMETIME.

When you go to work and earn money, you have to pay taxes. We all pay federal income taxes, most of us pay state income taxes, and some of us pay local income taxes (city and/or county). We also pay payroll taxes but those are not important in this discussion. Also, taken out of our paycheck might be things like health insurance, life insurance, and (hopefully) retirement contributions. The question is, in what order are these items taken out of your paycheck (because it makes a big difference).

Alright. Now that you know Rule #1, I can explain how taxes on retirement income work. Let’s start with a traditional 401(k) and then compare it to a Roth 401(k) so that you can see the difference.

Our friend Chuck works at the local fire department and makes $4,000 every month (this is referred to as his gross income). He has to pay federal income tax of 20%, state income tax of 5%, and no local income taxes. He also wants to put 15% of his income into a pre-tax (such as a traditional IRA or a 401(k)) retirement plan. This means that he pays $800 in federal income tax, $200 in state income tax, and he puts $600 into his pre-tax retirement account leaving him with $2,400 left over to be deposited into his bank account (net income). Here’s a chart to better see how it works:

Chuck’s Income

Gross Income	$4,000
Federal Income Tax (20%)	$800
State Income Tax (5%)	$200
Traditional 401(k) Contributions (15%)	$600
Net Income	$2,400

It is important to note that the traditional 401(k) contributions that Chuck made were based on his gross wages. This means that he has not yet paid taxes on this money. And remember:

Rule #1: Whenever you make money, you MUST pay taxes on that money SOMETIME.

This means that Chuck still owes taxes on the $600 that went into his traditional 401(k). When will he have to pay it? When he takes the money home to live on when he retires. This means that this money can grow tax-deferred (meaning that Chuck has deferred paying the taxes) until retirement.

Now let’s consider Larry. Larry works at the same fire station, makes the same income, pays the same taxes, and contributes the same amount as Chuck. The only difference is that Larry contributes 15% of his income into a Roth 401(k). This means that he is using after-tax dollars. Here is a chart to see how Larry’s income looks:

Larry’s Income

Gross Income	$4,000
Federal Income Tax (20%)	$800
State Income Tax (5%)	$200
After-Tax Income	$3,000
Roth 401(k) Contributions (15%)	$600
Net Income	$2,400

I hope you noticed that at the end of the day, both Chuck and Larry had the same net income ($2,400). So what is the difference between the traditional 401(k) and the Roth 401(k) if they both have the same net income? The difference is that with the Roth 401(k), Larry has already paid taxes on that money. While with the traditional 401(k), Chuck will have to pay taxes on it later. 

So let’s assume that (1) taxes were to remain the same throughout Chuck and Larry’s lifetime, (2) they both invest the same amount, (3) they both earn the same return on their investments, and (4) they both retire at the same time they should have the same amount of money. But Chuck will still owe taxes on that money, while Larry won’t. And the more money someone invests, they more they will owe on taxes because of Rule #1.

Rule #1: Whenever you make money, you MUST pay taxes on that money SOMETIME.

Because I like making charts, here is a chart on how the benefits of the Roth 401(k) compound over time:

	Chuck’s Traditional 401(k)	Larry’s Roth 401(k)
Amount After 1 Year	$4,000	$4,000
Taxes (25%)	($1,000)	($0)
Net Amount	$3,000	$4,000

	Chuck’s Traditional 401(k)	Larry’s Roth 401(k)
Amount After 5 Years	$20,000	$20,000
Taxes (25%)	($5,000)	($0)
Net Amount	$15,000	$20,000

	Chucks Traditional 401(k)	Larry’s Roth 401(k)
Amount After 10 Years	$40,000	$40,000
Taxes (25%)	($10,000)	($0)
Net Amount	$30,000	$40,000

	Chuck’s Traditional 401(k)	Larry’s Roth 401(k)
Amount After 20 Years	$80,000	$80,000
Taxes (25%)	($20,000)	($0)
Net Amount	$60,000	$80,000

The way that Roth 401(k)s are treated by the IRS is the most important part in understanding the benefits of them and now that you hopefully understand that.

Most of the rules regarding the Roth 401(k) are the same as the traditional 401(k). But let’s go over them briefly anyway.

1. Investments: The investments that you can have in a Roth 401(k) are the same as a traditional 401(k). Within a Roth 401(k) you can have many different investments such as:

7. Stocks
8. Bonds
9. Mutual funds
10. Unit investment trusts
11. Government securities (Treasury bills, treasury notes, and treasury bonds)
12. US government-issued gold and silver coins. 

If you don’t know what all of these different terms mean, that is perfectly fine. Just know that you can have nearly all investment within a Roth 401(k).

But, there are a few items that cannot be in a Roth 401(k). IRAs cannot have:

7. Antiques
8. Gems
9. Rare coins
10. Works of art
11. Life insurance contracts: This is because life insurance contracts are not securities (investments).
12. Municipal bonds: This is because putting a municipal bond in an IRA would negate the tax free status of the municipal bond.

Antiques, gems, rare coins, and works of art cannot be included in Roth 401(k)s because these items do not have a solid market value. Meaning: I might be willing to pay $50,000 for a painting, but you may be willing to only pay $3,000 for the same painting. It is too difficult to find an agreeable market value.

2. Contribution Limits (as of 2021): The Contribution limits with a Roth 401(k) are the same as a traditional 401(k). You can contribute up to $19,500 to a Roth 401(k) if you are 49 years old or younger. If you are 50 years old or older, you can contribute an additional $6,500 for a grand total of $26,000. This is known as the “catch-up” contribution. It is meant to help people who are a little bit older put more money in their retirement account because they have less time before retirement. The catch-up contribution can start to be made the year that you turn 50. So if your birthday is in September, you can contribute the full $26,000 starting in January of that year even though you are only 49.

Age	Maximum Contribution
Less than 50	$19,500
50 (the year you turn 50)	$26,000
Older than 50	$26,000

3. Income Restrictions (as of 2021): Income restrictions for a Roth 401(k) are the same as the income restrictions for a traditional 401(k). The rules regarding income restrictions for contributing to a Roth 401(k) are a little hard to follow. The important thing to know is that no matter what, you can contribute up to $19,500 ($26,000 if you are 50 or older) to your Roth 401(k) not including any match. The maximum eligible income for contributions to a 401(k) is $290,000. The income limit is best explained from this example from The Motley Fool:

For example, if you’re paid $400,000 and your employer also offers a 5% match on your 401(k) salary deferrals, you can contribute $19,500 in 2021. Your employer match will be only $14,500, though, instead of the full $19,500. That’s because it’s limited by the $290,000 compensation limit for 2021. Even though 5% of $400,000 is $20,000, 5% of $290,000 is only $14,500.

This leads us to the next important consideration of  Roth 401(k)s.

4. Employer Match (as of 2021): Most of the time, employers will match some amount that you put into a Roth 401(k). This is the BEST reason to invest in your 401(k). That’s because it is free money! My dad always had a saying: “If it’s free, it’s for me.” You should take this to heart. For example, if you make $4,000/month and you deposit just 5% of your paycheck into your Roth 401(k) and your employer matches 5%, you have effectively contributed 10% of your pay to your retirement. That is a great deal! People want to brag about investing and getting a 10, 15, or maybe even a 20% return. If you contribute at least the employer match into your 401(k) you have already achieved a 100% rate of return! You can’t get that anywhere else.

The importance of taking advantage of a 401(k) match cannot be understated. According to Chris Hogan and Ramsey Solutions, it is the number one way that people become millionaires.

Let’s talk about Bobby from earlier. Let’s assume that Bobby makes the average US household income of $68,000, is 31 years old, and will retire at 67. Here are some examples of how much he would have in his retirement account with various levels of employer-matching 401(k) contributions.

Cont. %	Cont. $	Match %	Match $	Growth %	Total W/O Match	Total W/ Match
3%	$2,040	3%	$2,040	3%	$315,183	$630,366
4%	$2,720	4%	$2,720	4%	$420,250	$840,500
5%	$3,400	5%	$3,400	5%	$525,299	$1,050,597
6%	$4,080	6%	$4,080	6%	$630,366	$1,260,731

As you can see, contributing at least up to the match is extremely important. It can double your money.

This is one of the big differences between a traditional 401(k) and a Roth 401(k) though. Any amount that the company has given to you in a match is automatically put into a traditional 401(k), not a Roth 401(k). So if you have a Roth 401(k) with a match at your employer that you contribute to, you will effectively be creating two different 401(k)s, a Roth 401(k) and a traditional 401(k). All the money that you put into it will go into the Roth account, and all the money that your company matches will go into the traditional account. The reason for this is because with a Roth 401(k) you are paying taxes on the money. An employer cannot put money into a Roth 401(k) for you (through the match) because the employer cannot pay taxes on your behalf. It’s not a really big deal, it’s just something to note. Either way, if you are contributing to a Roth 401(k) and it has a match, you are doing great!

5. Early Withdrawal (as of 2021): As stated in other articles about the different retirement accounts, you should never withdraw money out of a retirement account before you have reached age 59 ½. The money is there for you to retire with, not buy a new boat or go on a vacation. If you take money out of a Roth 401(k) before you reach 59 ½ you will have to pay a 10% penalty. You will not have to pay taxes on the money withdrawn because you already paid taxes on it when you put the money into the Roth 401(k). However, if you decide to withdraw money out of a Roth 401(k) before 59 ½, you can under two different umbrellas set by the IRS which are the same as for the traditional 401(k).

1. Hardship Withdrawals: The IRS allows for someone to take funds out of their 401(k) prematurely if they can demonstrate a hardship or fall under the “safe harbor” guidelines set forth by the IRS. This is outside the scope of this article but  can be found here.
2. 401(k) Loans: The IRS allows for loans to be taken out on a 401(k) account that have several different rules and regulations. The bounds in which someone can take out a 401(k) loan and the bounds of repayment of said loan also fall outside the scope of this article but can be found here.

6. Required Minimum Distributions (as of 2021): As with traditional 401(k)s, Roth 401(k)s have required minimum distributions (RMDs) once you reach the age of 72. This means that the IRS will require that you take out a small amount of the money you have in your Roth 401(k) account each month. What you do with this money is up to you. Some people spend it, some save it, some give it away, and some just reinvest it. The calculation for RMDs is outside the scope of this article, but it is important to know that you will be forced to withdraw some amount of money after you reach 72.

I understand that this is a ton of information, but it is important to have a decent understanding as to how the largest wealth building tool that most people have at their disposal works. With this, I hope that you have slightly grown your Money Muscle and you continue to become more financially fit. Until next time!