how does a 401k plan work

How Does a 401K Work? [How to Get a 50% Return]

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Americans are missing out on $24 billion in free retirement savings each year. Your piece of that could be as high as $250,000 if you don’t know exactly how a 401k works and how to take advantage of it.

In this video, I’ll show you how a 401k plan works, the average balance by age and how to get the most out of your plan. I’ll also reveal why I hate these plans but why you should invest anyway.

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how does a 401k plan work
How Does a 401k Plan Work?

The American Retirement Crisis

We have got a retirement crisis in America! Nearly half of all retirees depend on social security, about a thousand dollars a month. Worse though is that investors are passing up free money and the best return you’ll ever make.

A new study found that one-in-four Americans aren’t maxing out their company’s 401k match, missing out on $1,336 a year. That’s free money and at the market rate of return, it’s costing you over $250,000 over 35 years.

How Much Company 401k Match is Worth
How Much Your Company 401k Match is Worth

More than $24 billion of this free money is missed every year with younger people missing more. One-in-three workers between 25 and 30 are missing out on this free money.

I get it though. When you’re barely making enough as it is, you’re not thinking about maxing out your 401k plan and there’s a lot of confusion around what these plans really do.

We’re changing that in this video. I’ll show you how a 401k works and why it’s by far the best investment you’ll ever make. I’ll show you the average 401k balance by age and how much to put into your plan. I’ll also reveal why I secretly hate 401k plans but why you should invest anyway.

As an informal survey of the community though, I want to get your input here. Do you have a 401k plan at work and what is your company match? Does your 401k match dollar for dollar or 50%?

What is a 401k Plan?

A 401k is a special retirement investing account set up by your employer with a plan administrator, usually an investment company. The plan includes a list of stock and bond funds in which you can invest. You set up how much you want to invest regularly and that money comes out of your check before taxes are taken out.

Besides that pre-tax benefit, most companies will match a portion of your investment. So a typical company match is your employer will put in another half of what you put in up to 6% of your total salary. These are two huge benefits of a 401K plan, that tax benefit and company match.

So breaking this down. Your 401k plan is a special benefit set up by your company. You decide how much you want to put in from your paycheck and the company matches some of that, giving you free money rewarding you for saving. Your money goes into an account you own, managed by an investment company so totally separate from your employer.

Plus…PLUS! You don’t have to pay taxes on the money you put into your account until you take it out in retirement!

How Does 401k Vesting Work?

Now there’s a catch to how much free money your employer is going to give you. Most companies cap this at 6% of your salary. So if you save 6% of your salary for retirement, your company will match it or put in half depending on the program.

Think about that. If you make $30,000 a year, you only need to put in $1,800 a year, that’s 6% so about $150 a month, and your company is going to give you an extra $900 a month to retire on. That $150 a month on your part plus the company match is going to grow to over half a million dollars over 35 years and provide an extra $23,000 a year in retirement.

There’s one more thing you need to know about your 401k plan before we look at those average balances by age and a strategy to take advantage of all this. Your company will have a vesting schedule which is how much and when you get to keep the money your company puts in the account for you as a match.

I know, it sucks that you don’t get to keep all your company’s match immediately. You’ll always keep everything you put into your account but the company’s match is yours gradually. It’s just a way for the company to keep people around longer.

For example, we see the vesting schedule for workers at Sprint here. So if you are a Sprint worker and contributing to your 401K account, the company matches half of your investment up to 4% of your salary. If you make $40,000 a year, the company will match 50% of your contributions up to $1,600 so they’ll put in another $800 a year.

example vesting schedule 401k
Example Vesting Schedule 401k Plan

Sprint will put its match amount in every time you invest but according to this schedule, if you leave the company after a year then you only keep 33% or a third of what they put in. If you work two years and leave then you keep two-thirds or 66% of what the company put in.

This is actually a really nice vesting schedule. When I was an economist for the State of Iowa, the 401K vesting spread out over decades so it took much longer to keep all the employer match.

Average 401k Balances by Age

Here we see average 401k balances by age and this is data from Fidelity. So Americans in their 30s have an average of $38,000 saved in their 401k plan. By the time you get to retirement, so that age range between 60 and 69, the average American has just under $170,000 in a 401k.

401K balances by age

These red lines and the numbers on the right are what Fidelity recommends you have saved by that time and this is in number of times your salary. So by your 30s, they recommend having about two-times your annual salary saved. That recommendation increases to 9-times your salary by the time you retire so for example, if you make $36,000 a year then Fidelity says you should have about $324,000 in your 401k plan by the time you retire.

There is obviously a huge gap in that recommendation and what people actually have saved for retirement. That $168,000 average 401k balance is only enough to provide about $560 a month if you’re taking out 4% a year. Basically, the average retiree here is looking at running out of money in less than 10 years.

Of course, this is the average of people that have anything saved in their 401k program. This doesn’t even include the 48 million Americans with nothing saved at all, that’s three-in-ten people that will rely completely on about a thousand a month from social security to live on.

How to Get More from Your 401k

But this is a problem that is so easy to fix. Having that company 401k match means you only need to contribute a small part of your check to be ready for retirement. Going back to our example, if you’re contributing just $150 a month and getting a half match, then you’re set for a half million dollar payday in retirement.

Even contributing half that, so just $75 a month and getting your company match, means having over $250,000 by the time you reach 65. But I want you to try maxing out your company match, that’s the real secret to 401k plans.

This means finding out your company’s match rules. If they offer to match up to 6% of your salary, then contribute 6% of your salary. If they only match up to 3% then at least contribute that much. You can take it out of each check, just one check a month or even take the whole year’s contribution out all at once.

Is a 401k Loan a Good Idea?

Now I want to talk about 401k loans pros and cons and why I have a love-hate relationship with 401k plans.

I see a lot of people fall for the 401k loan trap and it can seem like a way to get a cheap loan. How a 401k loan works is you borrow from the account value, basically taking that amount out of your savings. You usually have five years to repay the loan and everything you repay, interest and all, goes back into your 401k account. So basically you’re paying yourself the interest.

That might seem like an interest-free loan and a good way to get a little extra cash but there are some big downsides to a 401k loan.

The downsides to a 401k loan are that you’re missing out on a lot of returns and company match while you repay the loan. Your money is not longer invested so the only return is that interest you pay and most plans won’t let you contribute while you pay back your loan.

That means no company match either. Even worse, if you leave your job and can’t repay the loan, you’ll owe a 10% penalty and the taxes on the amount.

So the simple answer is don’t borrow on your 401k account.

Why I Hate 401k Plans

Now after all this, after telling you why a 401k plan is such a great deal and how you absolutely must be contributing to your plan, I want to tell you why I hate these programs.

And the reason here is that 401k plans are so damn expensive!

The average 401k plan charges you 1% on your money each year just to run the plan. On top of that, you pay a fee for each fund you hold in your plan, an expense ratio that can average another 1% on the mutual funds.

And while I love exchange traded funds, those ETFs that trade like stocks and charge ridiculously low fees, most 401k plans only allow you to invest in mutual funds provided by the investment company. Those mutual funds are typically five-times more expensive than an ETF alternative.

Forbes found in one study that a difference of just 0.93%, less than one percent difference in fees, can cost a single investor up to $215,000 in their retirement.

Now the tragedy here is you really can’t do much about it. Your company sets up the plan with the investment company and the fees are set. I still want you to max out your company match because that’s free money, even despite those higher fees. Getting a 50% match on your contributions is like an instant 50% return. That’s the kind of return that would make even Warren Buffett salivate so don’t miss out on the benefits of a 401k.

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