The other day, someone asked me how I feel about 401(k)s. They told me that they weren’t sure about them and that they wanted to invest riskier but they hate not being able to touch it for so many years.
It’s awesome that the person asked this question, but it’s still amazing to me that it’s not something they (or I) were taught in high school…or ever.
Retirement Account
A 401(k) is a tax-advantaged retirement account setup by an employer to allow its employees to save and invest for retirement. Alternatively, you have the ability to set one up for yourself if you’re self-employed. Specifically, 401(k) is a section within the US tax code that allows this type of account to be setup. Additionally, there are other employer-provided retirement accounts such as 403(b)s, 457s, and others that are similar to 401(k)s.
Delayed Gratification
I think the issue of feeling anxious about not being able to touch the money for so many years is one of delayed gratification, which is the concept of giving up (delaying) something that may make you happy today (gratification) for something that is hopefully more beneficial in the future.
Is it more important to you to spend all of your money today and make sure that your neighbors think you’re well off or is it more important to you to feel comfortable with your future? Obviously, there needs to be a compromise. I think that almost everyone knows that they should be saving for retirement, but maybe not everyone really knows what a 401(k) is, how it works, or why they should potentially taking advantage of it if they have it available to them.
How It Works
There are different types of 401(k) accounts (pre-tax, Roth, after tax), so I’ll explain the one that most people probably think of – pre-tax. Contributing money to a pre-tax 401(k) [sometimes known as “traditional” 401(k)] allows you to lower your taxable income by contributing to the tax-advantaged retirement account. Once the money is in the account, you can invest it without paying any taxes on it until you withdraw it in the future.
Why not save in a brokerage account (a taxable trading account)? There’s no problem with saving in a brokerage account instead of a 401(k), but the reason you would consider saving in a 401(k) (assuming you were deciding between the two and were worried about not having access to your money for a long time) is due to the significant tax advantages of a 401(k) as mentioned above.
Here’s where the person who asked me about 401(k)s in the first place felt uneasy – if you withdraw money from the account before you reach age 59 ½, then you’ll have to pay taxes on the distribution as well as a 10% penalty. That’s not very fun, but it is a decent way to incentivize people to keep the money in the account until retirement rather than spending it on something along the way.
Free Money
Many 401(k)s are setup to have the employer match a certain % of employee contributions to the account. For example, the most common match is 3%. This could mean that if you contribute 3% of your pay to your account then your employer will contribute 3% of your pay as well. That’s free money. Employers provide 401(k) matches as an extra incentive to hopefully attract good, long-term employees.
Should I Contribute To A 401(k)?
As with everything in personal finance, it depends on what your goals are and the details of your personal situation. Probably most people have a goal to retire and saving to a 401(k) can be a great avenue to help them reach that goal. Even if you plan to work through the rest of your life, there may come a time when you’ll either no longer be able to work or you just won’t want to work to any more. Where does money come from to live at that time? Social Security? Are you comfortable banking on that and living off of that benefit alone?
I think your future self will be happy that your current self started saving now in a tax-advantaged account for retirement. Although there is no perfect solution I think that saving to a 401(k) is a good idea, especially since most people do not have enough saved for retirement and especially when you’re incentivized by free money from your employer.
