What is a 401(k) Account?
A 401(k) is a retirement savings account or plan sponsored by an employer. It lets workers and future retirees save and invest a portion of their paycheck pre-tax (before taxes are taken out). The money in the account is invested and grows free of taxes until the money is withdrawn from the account.This tax-free compound growth is the main advantage of this type of account vs. traditional investment accounts when saving for retirement. In a typical investment account, for every sale of stock, exchange traded fund, or other investment sale that results in a gain, there is a taxable event and you must pay income tax (if held for one year or less prior to sale) or capital gains tax (if held for over one year prior to sale). This is the largest advantage of a 401(k) account and the reason this type of account works so well for retirement savings. Having it set up as a pay yourself first system (where the funds are withdrawn automatically from your paycheck on pay day) and the compound growth (no annual tax on gains) make this an incredible vehicle for funding and growing your retirement savings.
What Types of Investment Options Do 401k Accounts Offer?
401k account investment options will vary from employer to employer as to investment options, some offer better options than others. Most typically offer mutual funds, some only a few, with others allowing the option of hundreds or thousands. Some offer the ability to purchase Exchange Traded Funds, Stocks, etc. Many typically offer age based (set it and forget it) investments with a 10, 20, 30 year time frame depending upon your age, where the asset allocation will shift from higher risk investments such as stocks to more risk averse assets such as bonds over time (although with interest rates so low right now and the fact that they are certain to climb higher, to me, bonds seem to be a risky endeavor as bonds lose value when interest rates rise). 401k investment fees can also vary greatly depending upon the investments you choose. Some funds such as Vanguard funds advertise their low costs as a way to draw investors to them. This is a very good reason to check out their funds as the lower your fees, the more you have invested and the more compound interest you will earn to grow your long term wealth.
Some 401k plans allow you to purchase almost any stock or ETF out there, even the Bitcoin Investment Trust (a trust that holds Bitcoin and trade over the counter at a premium to Bitcoin). If your work 401k allows for this option, or if you have an old IRA or retirement account and are able to do so, a self directed IRA is a great option as it allows the type of flexibility of investments that I am referring to. The great thing about this if you are younger and have a significant amount of time before retirement is that you can limit the number of stocks you buy and attempt to achieve massive returns for a few years in a row to give your retirement savings a boost. This can be more fun and rewarding than simply buying a mutual fund and staying put. Although traditional advice would tell you to put your money in diversified funds and leave it.
Can I Purchase Individual Stocks Through my 401k?
Although most 401k’s for large publicly traded companies will allow you to purchase their company stocks as part of your company retirement plan, some 401k’s even offer the option to open a brokerage account within your 401k which will remain tax free and grow tax free. Personally, I feel this is an incredible benefit as it allows the option for younger investors to take much larger risks (if they feel they can afford it) within a tax free investment. By larger risks I mean investing in one or a limited amount of growth stocks to attempt to achieve a larger return than a well diversified/allocated fund would achieve. Good solid financial advice and principals will tell you to avoid taking on the risk of investing everything in one or a limited number of investments. However, I personally at this point in my life feel that I am willing to take the excess risk to achieve an excess return. Due to this I have had my personal 401k go up as much as 82% this past year, and down 50% from the peak. I love owning individual growth stocks in my 401k. At this point, my wife and own over a thousand shares of Skyworks Solutions (SWKS), and shares of the Bitcoin Investment Trust (GBTC). These are not the most diversified investmentsThese are the kind of wild swings that can happen when you invest in one or a limited number of stocks at one time. I would never recommend this for others as I believe more often than not the financial success rules which state that you should properly diversify and allocate your assets will win out over time.
What Should I Invest In? Should I Follow Traditional Advice?
Investing is a personal decision. I feel that for each individual with their life goals as well as their financial goals and the decisions they make in life, they are personal decisions that you must feel satisfied with, be able to live with. For myself, I have always envisioned reaching a certain level of wealth, that is the life story I have for myself, and enjoy attempting to get there. I also feel that i am young enough to endure the risk and can in a few years play it much safer and still accumulate a certain amount of wealth by the time I retire, therefore i feel confident with the decisions i make and the amount of risk taken. Each individual must assess this for him/herself and be able to live with it. I don’t want to live with the regret of wondering what would have happened had I tried to achieve my dreams. I am working to achieve my dreams.
Tax Advantage of a 401(k) vs. a Traditional Investment Account.
Compound interest growth and employer matching are the main advantages of a tax free retirement vehicle such as the 401(k).
Employer matching can typically be anywhere from 3% to 6% or more. This is free money or a 100% match on the first 6% of funds you put into your 401k. For instance, my present or former employer offered up to a 6% match. If you make $100,000 per year for example in annual salary, this equates to an additional $6,000 each year as a match for the $6,000 you put into your 401k pre-tax. Therefore instead of investing $6,000, you now have $12,000 to invest for the next 30 years (assuming you are in your 20’s or 30’s.
Unlike a traditional investment account where you pay taxes each year on gains, a 401(k) provides for a deferral of tax on any gains until the money is withdrawn from said 401(k). This allows for additional compound growth within the tax favored 401(k) retirement account. To illustrate, let’s say Ms. X has $50,000 in her 401(k) tax favored retirement account at work and another $50,000 in a traditional taxable investment account invested in stocks. At the end of year 1 both accounts made 20% for the year (a $10,000 gain for each). This puts the value of the 401(k) at $60,000, and the value of the taxable account at $60,000 (before taxes). The 401(k) would not be taxed and thus to start year 2 all $60,000 would still be in the account and invested going forward. However, in the traditional taxable account Ms. X would pay 28% tax on the $10,000 gain for the year (having sold the stocks to accept the gain). This would leave her with only $7,200 to start year two for investing. Now at the beginning of year two, Ms. X would have $60,000 invested in her 401(k), but only $57,200 in her taxable investment account. Check out the difference over time by using our calculator below.
What is the Maximum Annual Contribution Limit for a 401(k) in 2018?
The maximum annual contribution limit for a 401(k) retirement account in 2018 is $18,500. This amount does not include employer contributions on your behalf. For example, if your employer offered a match of the amount of 4% of your base salary and your base salary was $50,000, $2,000 would be matched, thus the total 401(k) deposits would be $20,500 for the year (seemingly exceeding the limit; but the employer contributions do not count for purposes of the Maximum Annual Contribution Limit. This is an incredible benefit and you should take advantage to the full extent you are able to do so. With employer match you could well exceed the $18,500 put in each year, assuming your salary and match are great enough. Imagine how much this could grow to with even a decent historical rate of return….tax free until withdrawal.
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