401k For Dummies

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“Why aren't you signed up for the 401K? I'd never be able to run that far.” - Scott Adams

401k For Dummies

In today's piece, I'm going to answer a question that I was asking myself just a few weeks ago. As a new graduate out of college, I walked into my first job thinking I had my 401k all figured out before I even saw the benefits page.

Upon going to set up my account I found three options. A Traditional 401k, After Tax 401k, and a Roth 401k.

The after tax account caught me by surprise and made me think "do I actually know which is best for me?" I spent that evening researching and threw my findings into this email to share with you.

Having a 401k is one of the easiest ways to build wealth. But don't take it from me.

Choosing the right account can have a major effect on your retirement plans and tax savings in the future.

The problem is most people blindly pick an option then realize later on they should have paid a little more attention to the fine print.

Here is a cool stat. 80% of millionaires invest in their 401k.

Why is it so popular among high net worth individuals? Probably because they like free money and tax savings.

What is a 401k

Here is a simple breakdown by Investopedia.

A quick example. Assume you make $100k annually before taxes. Your company offers a 6% match on your 401k contributions.

This means that your company will match every dollar you invest up to 6% of your salary. So since you are making $100k, you invest $6k and your company also invests $6k on your behalf. Yes, it's free money.

The tricky part is the difference in contributions depending on what type of 401k you select.

Traditional 401k

This is the first account most people think about when they think of 401ks.

With a traditional account, your contributions are deducted from your pre-tax income. Using our same example, your $6k in contributions would be subtracted from $100k (pre-tax salary). This will reduce your taxable income for the year and can be used as a tax deduction.

Taxes are not owed on the contributed money until it is withdrawn from the account where it is treated as ordinary income.

Roth vs After Tax

Pay attention here, because if I'm being honest it's where I got lost the first time.

Both the After-tax and Roth 401k options use after tax contributions. This means your $6k will be subtracted from your salary after taxes are taken out. While this is a key similarity, here are the differences in the two.

Roth 401k

Not so fast. As previously mentioned Roth contributions are made with after tax income. While that might not sound as appealing, if done right you won't ever have to pay taxes on that money again.

The main rule to withdraw your gains tax free one must be 59 1/2. Unqualified withdrawals will have a 10% IRS penalty along with normal income taxes added on. Remember, you can take out your original contributions at any time penalty-free.

Here is what many people miss. Your employer match is not considered a Roth contribution and will go into a traditional IRA account (will be taxed on withdrawal).

The contribution limit for a Roth 401k is $23,000 per year (Roth + Traditional combined). If over 50 this increases by $7,500. It's also important to note that employer's contributions don't count towards the employee contribution limit, though they do count towards the combined (employer + employee) limit of $69,000 for 2024. This also applies to the traditional 401k option.

P.S. There is no income limit for the Roth 401k.

After Tax 401k

I'll make this as simple as possible.

The main difference with the After Tax 401k is that your gains will be taxed upon withdrawal in retirement. While not as tax advantaged as the Roth, only having to pay taxes on the gains is still better than in a traditional 401k where both contributions and earnings are taxed as ordinary income.

Contribution limits on the after tax 401k are also different and are only subject to the overall limit of $69,000 (+$7,500 if you are over 50).

Which Is Right For You

Here are the general rules for choosing a 401k plan.

The Roth 401k is typically recommended when you expect to be in a higher income tax bracket in retirement. Aka, you expect to be the ole geezer balling on the golf course. 

Especially for young people. Your dollars have a lot of power and not being capped by taxes is amazing. That's why the Roth 401k it's my favorite option.

If you think you are in a higher tax bracket now than you will be in retirement it's generally accepted that the traditional 401k is the better option. The traditional 401k will reduce your current tax bill and and allow you to pay a lower income tax later on.

The after-tax option is usually only considered after contributing the annual limit to one's traditional or Roth 401k.

This is broad advice. Several other factors that play into this decision including time horizon, income, and personal finance goals.

At the end of the day, I'm just a dude on the internet. If you need help getting your 401k setup, please consult a CPA.

Surprise! I already have two for you.

My friends Brennan Schlagbaum (@Budgetdog_) and Mark Roussin (@Dividend_Dollar) are both CPAs and helped to make sure the information in this email was correct. Either would be more than happy to answer those "financial advice" questions.

Till next time, Cade

(If you want to run the numbers for yourself here is a 401k calculator to check out.)

Best Memes Of The Week

Incase you missed it the fed hiked rates another 75 points. While the market didn't like it, the memes loved it.

What I liked this week:

Roth IRA vs Roth 401k - YouTube video by The Money Guy team going more in depth on the similarities and differences of a Roth IRA, Roth 401k, and Traditional 401k.

Fidelity 401k contributions - Want another angle? Check out this Great article by Fidelity covering 401k contributions.

Nothing in this email is intended to serve as financial advice. Do your own research. Thanks for reading, if you have any questions, comments, suggestions, etc. about the email shoot me a reply. Have a good one.