FINANCIAL FRESHMAN #023
TL;DR → Your future employer may offer you a 401(k) plan as part of your total compensation package. To understand the mechanics of what you’re being offered, make sure you understand the servicer, investment options, account type, employer match, and your vesting schedule, if applicable.
A Quick History Lesson
In 1978, the United States Congress passed the Revenue Act, which (among other things) added section 401(k) to the Internal Revenue Code. This legislation gave us the 401(k) plan that many of us take advantage of today. By 2019, it was estimated that these plans housed almost $6.5 trillion dollars in total wealth.
Even long before they are employed, most people understand anecdotally what a 401(k) plan is. You know that it is something that supports your retirement, and that it’s a fund that both you and your employer may pay into. Even still, understanding the mechanics of these funds is critically important, especially when you consider that yours could have hundreds of thousands of dollars in it one day.
In this post, we’ll outline exactly what these retirement plans are, what makes them beneficial, and how you can decipher the 401(k) jargon you may find in your job offer letter. We’ll start with the basics.
What is a 401(k)?
A 401(k) is an employer-sponsored, tax-deferred account that you can use to invest in your retirement. The primary perk of a 401(k) is its ability to help you grow your savings through investments, while taking advantage of tax benefits. Over time, compounding returns and employer contributions can significantly boost your account balance.
Your employer will work with a financial institution to service your 401(k), so you will likely have to make an account with one of the institutions below. This is certainly not an exhaustive list, but this covers the common 401(k) servicers in the United States.
Before you reach the point of setting up your 401(k), you’ll likely receive a job offer that outlines some of the key details about the plan. Employers often include this information in the offer letter, as the 401(k) is an important benefit designed to attract and retain talent.
Evaluating a 401(k) Plan
When you’re evaluating an offer letter to learn more about your 401(k) plan, you should picture four checkboxes that you need to consider. If you can check off each of the four, you can be confident that you have all the details you need to make the best decision for your personal finances.
In the four sections below, we’ll talk about each of these check boxes, and tie them back to the jargon you’d likely see in your offer letter. An offer letter may give you insight into the entirety of this list, but leverage the employer’s Human Resources department if it does not.
Checkbox #1: Servicer & Investment Options
We covered above who your 401(k) servicer may be, but we didn’t discuss the implications that may have to the investment options that are available to you. Within 401(k) plans, it’s common to have access to index funds, target date funds, bond funds, or company stock funds if your future employer is publicly traded.
If you could benefit from a beginner’s guide to index funds, check out our recent post on that exact topic.
To successfully evaluate your future 401(k), make sure you are aware of who services your account, and what investment options may be available within your plan. Choosing the right diversified approach will be critical to your retirement success.
Job Offers May Say…
“Your 401(k) plan will be administered by Fidelity Investments.”
“Our company retirement savings plan is serviced by Charles Schwab.”
“Our competitive 401(k) plan gives you access to a full suite of Vanguard funds, including their flagship target-date funds.”
Checkbox #2: Available Account Types
Aside from who is servicing your account and what types of funds they make available to you, you may also have to select whether you want to invest in a Roth or a Traditional 401(k).
In a future blog post, we’ll cover the best ways to understand whether Roth or Traditional funds are best for your situation. For the purposes of today, just make sure you understand the difference.
In a Traditional 401(k), you will make contributions to your account with pre-tax dollars, effectively reducing your taxable income that year. You will then pay taxes on both the contributions and any investment growth when you withdraw the money from your 401(k) in retirement.
In a Roth 401(k), you will make contributions with after-tax dollars, meaning the money is taxed upfront. However, you will be able to withdraw both the contributions and any investment growth tax-free in retirement.
Not to complicate things further, but you can also contribute to both!
Job Offers May Say…
“Employees may contribute pre-tax dollars to a Traditional 401(k) account.”
“You can choose to contribute to a Traditional 401(k), a Roth 401(k), or a combination of both.”
“Our associates can take advantage of Roth 401(k) contributions for tax-free withdrawals in retirement.”
Checkbox #3: Employer Matching
You certainly shouldn’t overlook the other checkboxes, but this is likely the one you’ll be eager to find in your offer letter. This is where your employer essentially offers “free money” to help grow your retirement savings. Matching contributions are a key benefit that can significantly increase the value of your 401(k) over time.
If your employer matches 100% of the first 3% of your salary, for example, this means that for every dollar you contribute, they will contribute an additional dollar, capped at 3% of your salary. If you make $50,000 per year and contribute 3%, your account would be funded with $3,000 per year ($1,500 from you, and an additional $1,500 from your employer).
Always aim to contribute at least enough to get the full employer match. It’s essentially part of your total compensation package and can make a huge difference in your retirement savings over time.
Job Offers May Say…
“Employer matching is offered dollar-for-dollar on the first 3% of your pay.”
“We match 100% of your contributions up to 3% of your salary, and 50% of next 3% of your salary.”
“Our matching contributions are capped at 4% of your annual salary.”
Checkbox #4: Vesting Schedule
While the employer match is the offering that may get you in the door, the vesting schedule is what the employer hopes will keep you working there for years to come.
The employer match, while incredibly valuable, may not be money that you are entitled to right away. Many employers implement a vesting schedule, which determines how much of their contributions you “own” based on how long you stay with the company.
For example, your plan might have a graded vesting schedule, where you earn ownership of a percentage of the match each year. For instance, you might own 20% after one year, 40% after two years, and so on, becoming fully vested after five years. You could also have more of a cliff-style vesting schedule, where you are entitled to none of the employer contribution until you hit a certain milestone.
Understanding the vesting schedule is critical because leaving a job before you’re fully vested may mean forfeiting a portion (or all) of your employer’s contributions. However, any money you personally contribute to the plan, along with its investment growth, is always 100% yours.
Job Offers May Say…
“Employer matching contributions are 100% vesting immediately.”
“The company contributions to your 401(k) plan become 33% vested after one year of service, 67% vested after two years of service, and 100% vested after three years of service.”
“Our vesting occurs on a graded schedule, at 20% per year starting after the first year of service.”
Final Thoughts
Understanding the mechanics of your 401(k) plan is the first step toward making the most of this valuable retirement benefit. By learning how to interpret your offer letter, take full advantage of employer matching, and select the best investment options for your goals, you can set yourself up for a more secure financial future.
Next week, we’ll explore the lesser-known aspects of 401(k) plans, uncovering details that often go unnoticed.
