Many employers today offer a 401k to its employees. The benefits of a 401k is it’s allows the employee to set aside income towards retirement before taxes. This means that the employee’s earned taxable income is reduced. The Revenue Act of 1978 added a provision to the IRS code (section 401(k). This code allowed for employees to avoid being taxed on deferred compensation. 401k’s can be solely employee funded or they can have employer matching contributions. Contributions limits for 401k’s in 2020 under the age of 50 was $19,000 with a catch up provision for those over 50 of an additional $6,000, totaling $25,000.
401k’s rise in popularity in recent years has been driven by employers wanting to provide more attractive benefit options for perspective employees. Many times, if salaries are the same, the determining factor for a perspective employee will be what’s in the benefits package. Matching employer contributions, means the employer contributes “matches” employee contributions up to a certain threshold. Typically matching contributions are 3-5% but can go as high as 10%. 401k plans when matched by the employer are very attractive to employees as well as provide a tax deduction benefit to both the employee and the employer. 401k’s are also available now in a traditional format or as a Roth 401k, which grow tax free just like a Roth IRA.
401k’s however are just a vehicle. How that vehicle performs, in this case the underlying investment choices, determines what type of vehicle you have. You can have a 401k that’s a Ferrari or you can have a Toyota Corolla. Understanding the investment options for many sometimes leaves them shaking their heads. Many times I get blank stares when I asked the follow up question to perspective clients, “do you know how your 401k is invested?” Investment choices depend on several factors which I will cover in a future post.
For now, let’s answer the following question: Should I use my 401k over an individual IRA? Well, that all depends. I’m going to present you with three rules of thumb as to contribution order for investing with or without a 401k option.
401k Employer Match
If you should be fortunate enough to be working for an employers who matches your contributions into your 401k, then you should fully take advantage of that benefit. If they offer 4%, match the 4%. If they offer more, take it! That’s free money being given to you. Think of it as a raise to your salary. And it’s growing tax deffered which lowers your current taxable income. This can be very useful if you are in a higher income tax-bracket.
No 401k Employer Match
If you do not work for an employer that provides a match to your employee contributions in a 401k, the your first choice for a retirement vehicle should be either a Roth IRA or a Traditional IRA. Your adjusted annual income will be the determining factor in which option you choose. If you modified adjusted gross income is more than $137,000 for a single filer or $206,000 for a joint filer, then your choice has to be a Tradiotnal IRA. This will also provide you with a tax benefit. If your modified adjusted gross income is less than the treshold presented above, you choice has to be a Roth IRA. For more specific information about Traditional and Roth IRA’s, please chech out my post on that topic.
Door number 3
A third and final option comes about when you would like to contribute more to your retirement that the IRA contribution limits allow. You maxed out your annual Roth IRA contribution, but get no employer match on the 401k. Here’s were you should now use the 401k. You set aside $6,000 or $7,000 in your IRA and still have the ability to contribute up to an additional $19,000 or $25,000 towards your retirement.
There is the order in which 401k’s and IRA, either Roth or Traditional, should be funded. Remember, the concept of possible performance of the vehicle type will be the topic of a future post.
If you would like a review of your 401K’s performance, please email me directly at louis@louisromero.com.