In Episode 3, I discuss a comprehensive framework for understanding how 401ks work and how to use them strategically.
What you’ll learn in this episode:
- Origins of the 401k and some interesting stats
- Tax deferral
- Withdrawal age + tax at withdrawal
- Other: Rollovers, loans, beneficiaries, creditors, inheritance
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Links mentioned in this episode:
- Get my 401k cheat sheet for quick and handy reference
- All about Solo 401ks
- HYW private Facebook community
Read this episode as a post:
All right. Thanks for tuning in for Episode Three of the podcast.
I’m excited by today’s episode because I’m going to be talking about a topic in the invest part of my 4×4 fire framework, which we covered in the last episode.
The four pillars being earned, save, invest and protect.
Check out Episode Two, to get the full overarching picture of the 4×4 FIRE framework which I evangelize and I use in my own personal finance portfolio management. Definitely encourage you to check that episode out.
So today I’m going to start off by talking about some of the origins of the 401k and some interesting stats around it.
And then I’m going to get into some details around how contributions, tax deferral, withdrawal age rules, taxes at withdrawal, required minimum distributions, all those things, work.
As well as some strategies and rules you need to know around how rollovers work, and loans from your 401k, specifying beneficiaries, how 401ks are treated by creditors and in inheritance scenarios, and all the gory details you need to know so by the end of this episode, you should be fairly expert on everything you need to know about 401ks.
And we’re going to use the mini outline that I just laid out as our framework for understanding everything we need to know about 401ks.
So I summarized that little mini framework as a helpful free cheat sheet for you that you can have as a quick reference.
You can grab it by going to the show notes for this episode, hackyourwealth.com/3.
And so you don’t have to take any notes or write anything down or worry that you’re going to miss anything if you’re listening to this while commuting or jogging or just not in front of your computer.
Alright, so before we dive in, I also want to make sure I invite you as always to join my facebook group for HYW. You can access it at hackyourwealth.com/fb.
And it’s a way for us to connect, to have a two way dialogue. I’m in there every day responding to every single question and comment that’s posted.
And it’s also a way to meet other other people who are members of the community and are really interested in things like FIRE, financial independence, retire early, tax strategies, real estate investing, side business income, online income, career transitions, and even just asking for advice.
So please check that out hackyourwealth.com/fb
Be sure to answer the three short onboarding questions and I’ll let you right in.
Okay, so you may think that talking about how 401ks work and the tax rules around them are sleep inducing.
Like maybe your eyes glaze over because it sounds so technical and boring.
But you’re going to want to plug into today’s episode because outside of Social Security, there is perhaps no other retirement source of money out there as important and as instrumental to American retirement as the 401k retirement plan.
And knowing the rules and some strategies around it will help you take the right actions during your working years to build a million dollar retirement portfolio or even multiple million multiple millions, by the time you retire.
And that financial security is something I think it’s safe to say we all want.
So I’m excited by today’s episode and I think it’s worth your time to tune in and pay close attention.
Okay, first let’s start off by talking a little bit high level about what a 401k means what it stands for.
I’m going to breeze right through this because I assume that you already have some of the basics, but just so we’re all level set.
401k is a tax deferred, defined contribution pension account that is defined in Section 401k, hence the name 401k, of the Internal Revenue Code, which is the tax code.
The 401k as an as an investment vehicle account, was born basically about 40 years ago with the passage of the Revenue Act of 1978. So this was a law that was passed in 1978.
And the actual mechanics of interpreting the tax code and learning how it allows you to create this 401k type of account is widely credited to a man named Ted Benna, who’s regarded as sort of the father of the 401k.
Ted Benna was a benefits consultant for many years. He’s still alive. I think he’s living in Pennsylvania or something.
And he’s widely credited for figuring out how the tax code actually allowed employers and individuals to save money in what we now know as a 401k account.
Now, today, assets in 401k plans have swelled to more than $5 trillion. That’s trillion.
And the impact is probably double that if you count things like rollovers into IRAs.
And so after that 1978 law was passed, Ted Benna comes on the scene.
And in the fall of 1980, he is helping a bank client redesign their retirement program. And he is looking at this 1978 law and the tax code and he put some creative pieces together that just hadn’t been done before.
And those pieces were figuring out how different parts of the tax code actually linked together and interact with each other.
And basically he came up with the understanding that, hey, under this new 1978 law that was passed, employees can now actually make pre tax contributions to tax deferred retirement plans.
And employers can encourage employees to do that by offering matching benefits.
Now, there wasn’t anything in the tax law that explicitly said that employees can contribute tax deferred money and employers can match that.
But Ted Benna, who was reading the tax code closely, realized there wasn’t anything that was prohibiting that either.
And so when he brought this up, he was a partner at a small Employee Benefits consulting firm.
And he brought this up with his other partners, the senior partners looked at him and said, “Well, look, man, if this is possible, how come all the top tax lawyers and other major benefits consulting firms haven’t latched on to this? How can they haven’t seen it or come up with it?”
And he just said, “Hey, man, I don’t know. But it seems clear to me that this is possible in the tax code.”
And at first, you know, they were trying to socialize this with different newspapers and media outlets.
And there wasn’t really that much interest in is kind of obscure thing.
But eventually, it started actually to get a little bit of traction.
And from what I understand, there was a news article that was run in the Philadelphia Inquirer, which picked up the story.
And the journalist who wrote that article then got hundreds of calls in after the story around saying, “Hey, this is illegal. You can’t do that.”
And you have to remember that this is at a time when the idea of employees saving for retirement was really new.
It just wasn’t something that was very popular back then.
And Ted Benna talks about how he brought this 401k idea to one of his clients Bethlehem Steel and took it to the human resources department. And HR said, “Look, we take care of our employees forever. They don’t need to save for retirement because we give them a pension.”
And as it turns out, Bethlehem Steel went bankrupt in 2001.
But Ted Benna pushed on and recommended this type of novel retirement account structure to other clients.
And the first 401k plans were really quite simple.
They were certainly much simpler than the ones we have today.
They basically only had a couple of options, a bond like option and an equity like option where you could put either 100% of your money into one or the other or split it 50/50 or do 75/25.
But it was really quite simple.
And then over time, because employees wanted specific mutual funds to be added to their 401k plans, you saw these plans start to grow to four options and five options and six options and so on.
And so over time, the plans actually got more complicated.
So that’s a little bit of background, just kind of fun trivia for understanding where 401k plans came from.
Now, I mentioned a moment ago that a 401k is a type of pension account. But unlike, you know, pensions of the old days, a 401k is obviously funded by you, whereas a traditional pension as you might think of it is straight up paid by your employer as a retirement benefit for years and years of service.
So that’s the difference.
Sometimes you’ll hear this term defined contribution. That is what a 401k plan is, and that’s where an employee makes contributions on a regular basis into the account, maybe an employer contributes a matching portion as well.
Whereas a defined benefit plan is like the old type of pension plan from the old days where the employer promised a specified payment when you retire that was calculated based on your earnings history, how long you worked there, like your number of years of service and your age, rather than how much you put in to an account, and how much investment return that account accrued.
401k is also tax deferred, as you know, so that means you don’t pay pay taxes right now, those taxes get taken off your income when you make a contribution, but you pay taxes when you withdraw the money.
So really, the right way to think about the difference between a defined contribution and defined benefit plan is that one is your problem and the other is your employer’s problem.
A defined contribution plan is your problem because you put the money in but the employer is not responsible for your retirement when you leave.
And a defined benefit plan is your employer’s problem because you don’t have to put anything in and as long as you put in your years of service and do the things you’re supposed to do, your employer is required to pay you what you’re entitled to when you retire.
Defined benefit plans are definitely increasingly rare. And the really big one that permeates American retirement is Social Security.
Because that really is based on how many years you worked and how much you earned while you worked.
You should know that only employers can sponsor 401k plans for employees.
You can’t set that up by yourself.
The way to do individual retirement contributions is through an IRA. But there are specific types of 401ks that solo business owners or small business owners can set up.
We’ll talk about solo 401ks later.
And in terms of how 401ks are regulated, they are basically governed by the Employee Benefits Security Administration.
It’s a federal agency that enforces pension plan regulations.
And then obviously the IRS oversees federal tax laws that relate to pension plans like 401k and other types of retirement accounts.
Now one thing folks are sometimes curious about is what are target 401k savings goals by age.
Different institutions have different guidelines.
So for example, Fidelity, the big investment management firm, their rule of thumb is for you to save at least 1x your salary by the time you’re 30.
3x your salary by the time you’re 40.
6x your salary by the time you’re 50.
8x by the time you’re 60.
And 10x by the time you’re 67.
Now the things that are going to affect your personal target 401k goals are obviously going to be things like the age you plan to retire and the lifestyle you want to have in retirement.
And so that’s just a rule of thumb that Fidelity has, not necessarily a prescription.
Interestingly, since Fidelity manages a lot of money, they have some really interesting statistics around average 401k balances and even have that broken down by age.
So across their entire portfolio, the average 401k plan balance is about $106,000 currently.
But when you actually break it down by age, investors in their 20s have an average balance of about $12,000. Although it looks like the median is only about $4,300, which means that there’s probably some heavily skewed accounts toward the upper range.
Folks in their 30s have an average 401k balance about $42,000 while the median is $16.5k.
And 40 something year old investors, so folks who are 42-49 have average balances of about $102,000, almost $103,000 actually, while the median balance is $36,000.
Then folks in their 50s with Fidelity look like they have an average balance of about $174,000, median $61,000.
And then folks in their 60s have an average balance of about $196,000 and a median of $62,000.
Okay, so those are some stats that I think you would just find interesting about 401ks.
Now let’s shift gears and talk about how 401ks actually work in some detail.
So we’re going to cover contributions, tax deferral, withdrawal rules and taxes, required minimum distributions, and a grab bag of things like rollovers, loans, beneficiaries, creditors, etc.
So we’ll just use that little mini outline as our framework for deep diving and understanding the nitty gritty.
Let’s talk first about contributions.
So, the 401k max contribution limit in 2019 is $19,000.
That means you can put in $19,000 and deduct that from your taxes. In 2020, it is going to be $19,500.
But that’s just the portion that you as an employee can contribute tax deferred.
The total amount, you can actually contribute as much higher.
It’s actually $56,000 in 2019 and $57,000 in 2020.
The reason why it’s so high is because it accounts for not just the tax deferred component of your contribution, but also the after tax component of your contribution, which we’ll talk about, what that is and why it’s important momentarily.
And it also includes any employer matches that your employer contributes into your plan.
But there’s also a 401k catch up contribution for older investors.
So if you’re 50 or older, you can actually contribute an additional $6,000 into your 401k in 2019, $6,500 extra in 2020.
So that means your all in that you’re allowed to contribute isn’t $56,000 total if you’re 50 or older, it’s actually $62,000 for 2019 and $63,500 in 2020.
Now, I mentioned a moment ago that the total all in cap for 401k contributions isn’t just $19,000. Again, 2019 numbers, it’s actually $56,000.
And the reason for that is because sometimes a 401k plan will allow you to contribute after tax money.
This isn’t true for all plans.
It really depends on whether your employer enables this feature.
But something like 42% of 401k plans actually allow you to additionally contribute after tax money on top.
Now, there’s normally no reason to do this because there’s all kinds of downsides, like the money’s locked up until you’re 59 and a half.
Otherwise, if you take it out before, then you’re going to pay a penalty.
It’s subject to ordinary income taxes, not capital gains taxes, so the tax rate is higher.
The only reason why you would do this, why you would put an after tax money on top of your $19,000 pre tax money is to convert to Roth.
This is what is sometimes called the mega backdoor Roth conversion.
Mega because you can basically turbocharge your wealth building pretty dramatically by being able to contribute an extra $37,000 into a tax deferred, then immediately rolling into a tax free account, which then grows tax free forever.
Whereas with a regular IRA or Roth IRA, your contribution limits are much, much lower, like $6000 bucks roughly.
And so the way a mega backdoor Roth conversion works, the teally quick summary version is that the moment your after tax contribution lands in your 401k account, before you’ve invested in anything, and before it’s had any opportunity to fluctuate in value, even a penny, you convert it to Roth.
And so there’s no tax to be paid at that moment of conversion because it was already after tax money to begin with, and there was no gain on the tax.
And so once it’s in the Roth account, thereafter, all the gains on it are going to be tax free.
Even though you still can’t take the money out until you’re 59 and a half, it’s much better for that money to grow tax free, than to be subject to capital gains taxes over time.
So that is why it is so powerful if your 401k plan allows after tax contributions that go up to the very max of $56,000 or if you’re an older investor 50 or older $62,000, why it’s so powerful to actually utilize that to charge your Roth investments.
Now, you can can do that conversion either directly inside the 401k, if your employer has a 401k plan that has a Roth option set up directly in it – my employer actually does have this option, where every employee has not only a 401k account, like a normal one, but also has a Roth 401k account.
My employer even has a setting that you can check where the conversion just happens automatically.
You don’t even have to set up a calendar reminder to remind yourself to go in and do the conversion because it just happens automatically and instantaneously, the moment the money hits.
But if your employer doesn’t have those kind of tools, you can still do it manually.
You would just have to take that after tax contribution, just that slice not the pre tax portion, just the after tax portion. That’s very important.
Just take that after tax portion of $37,000. So if you max out to the full $56,000, take that slice and roll it over to a regular IRA.
An outside regular IRA, that you would sign up from any brokerage, like Vanguard or TD Ameritrade or whatever.
Toll that money over into the IRA. And that IRA is set up only for the purpose of doing these conversions.
And then once that money lands in the IRA, then do a conversion to a Roth IRA.
So that means you’re going to want to also have a Roth IRA that’s linked to that IRA.
So, even though it may sound like a number of steps, stay with me here, you deposit your after tax money into your 401k, then you will immediately roll that out to an external IRA.
Once it hits the external IRA, you immediately convert that into your Roth IRA.
And that pass through will incur no tax and that money will grow for the rest of its life tax free.
That is why that is so powerful.
Okay, in terms of tax deferral of your initial contribution of $19,000, of course, you know that when you contribute money to a 401k, that money is excluded from your taxable income.
It’s not technically a deduction, it’s actually just an adjustment to income before you even get to taxable income, and it’s just simply excluded entirely.
So that’s what it means to defer those taxes.
But then when you withdraw, there are lots of different rules that you have to know about.
The first one is around the withdrawal age.
You probably know that the withdrawal age for 401ks and IRAs and Roth IRAs, for that matter is 59 and a half.
You have to be 59 and a half years old to withdraw with no penalty.
And if you withdraw before then you’re not only going to pay taxes, at ordinary tax rates on the proceeds. You’re also going to pay at 10% penalty on the entire withdrawn amount.
And that could easily wipe out a bunch of your returns over the years. So, if you didn’t even make 10%, it’s going to actually cut into your original principle that you deposited in.
Once you reach 70 and a half years old, not only are you able to take the money out, now, you’re going to also be required to take certain amounts out each year.
And that’s because when you contributed to the 401k, you didn’t pay taxes.
And that was on the assumption, the government had the assumption that you will eventually pay taxes before you die on that money.
And once you reach about 70.5 years old, the government is starting to wonder how much longer you’re going to live.
So they’re gonna start forcing you to take money out and start paying taxes on it.
That can get unpleasant at times, because maybe you don’t need the money or you don’t need that much money, but still, the government’s going to start requiring to take out increasing amounts of your 401k and pay taxes on it, whether you want to or not.
And so in a moment, I’m going to talk a little bit about how to manage some of that risk.
One thing also to know about withdrawals is that there is a way to take a loan out from your 401k.
You can actually borrow money from yourself, you can borrow money out of your 401k plan and pay it back over a period of years.
You generally have to pay it back within five years. And the interest you pay actually just goes back to yourself, you just pay right back into your account.
So it’s kind of like taking money out of your right pocket and putting it back into your left pocket.
And at the time that you take out the loan from your 401k, you won’t have to pay any taxes on the amount that you borrow because it’s debt, it’s considered a loan.
But if you don’t pay back the full amount that you borrow, according to the repayment plan, that you are required to sign when you take out the money, then any loan amounts that have not been paid back are actually going to be considered a taxable distribution.
So, you’re going to be subject to that 10%, early withdrawal penalty, if you’re not yet 59 and a half. And also, you’ll have to pay ordinary taxes on top of that as well.
So it’s very important if you take a loan out from your 401k, that you are confident you’ll be able to pay it back with interest within five years.
Now, there are also some rules around early withdrawal from a 401k.
Usually, as you know, there’s a 10% penalty for withdrawing your 401k money before you reach 59 and a half.
But there are some exceptions to this rule and one of them affects early retirees in particular and it’s often referred to as the rule of 55.
And the rule of 55 says that if you are an employee who has been laid off, fired, or you quit your job between the ages of 55 and 59.5, then you can actually pull money out of your 401k or 403b plan.
This also applies to 403b plans, which are for public school teachers and certain tax exempt organizations.
It applies to both of these types of accounts without any penalty. So workers who leave their jobs anytime between 55 and 59 and a half, there’s a slight nuance to this you need to be aware of, which is that the rule of 55 only applies to the assets in the specific 401k or 403b plan of the employer you just left.
So if you had, worked for many companies throughout your career, it doesn’t apply to the earlier companies 401k plans if you haven’t already rolled them over into your current employer.
So for those earlier 401k plans, if they are not already rolled over, you’re going to have to wait until 59 and a half to withdraw that money from those accounts if you want to do that without paying the 10% penalty.
So, one strategy to give yourself access to retirement plan assets from those former employers before 59 and a half is to simply roll the assets over into your current 401k plan before you retire from your current job, or before you leave that job.
And that strategy is going to give you access to those funds penalty free if you don’t want to wait till 59 and a half to take that money out.
You should note that that the rule of 55 does not apply to IRAs. So if you move assets into a rollover IRA, upon leaving your job, you cannot then withdraw that money under the rule of 55.
That money in an external IRA is now going to be locked up until you’re 59 and a half.
Okay, let’s talk a little bit about RMDs, required minimum distributions.
So this is when you turn 70 and a half, the government starts forcing you to withdraw money from your 401k because it needs to get paid its taxes.
And so your RMD amount is determined by applying a life expectancy factor that the IRS has a mortality table for, and applies that to your age.
And that life expectancy factor decreases as you get older because you are getting closer and closer to passing away.
And that means that the RMD, the required minimum distribution you have to pay is going to get larger and larger every year because you divide the amount of money in your 401k by the life expectancy factor.
And as that number, that life expectancy factor gets lower and lower the amount you’re going to have to withdraw each year it gets larger and larger.
Okay, so I wanted to talk about 401k is versus other type of account types.
Just very briefly, so you have a lay of the land.
A Roth 401k works similarly to a regular 401k except that you are contributing after tax dollars the whole way through. There’s no tax deferred or pre tax portion.
Also, you should know that if you do a Roth 401k option, your employer match if you have one is always going to be pre tax.
Roth 401k also has required minimum distributions just like their regular 401k siblings.
And that’s different than Roth IRAs. Regular IRAs also have required minimum distributions, but Roth IRAs do not.
So that is actually one of the big benefits of keeping a Roth IRA, potentially even rolling money over into a Roth IRA, because if you don’t need the money, you won’t be forced to withdraw it from a Roth IRA at age 70 and a half, whereas for a Roth 401k you will have to do that.
Okay, next I want to talk about solo 401ks, which work similarly to a regular 401k.
But they’re designed for sole proprietors, like self employed people with no employees, or sole proprietor who maybe works alongside with their spouse.
And with a solo 401k you can actually make contributions as both employer and employee. So as an employee, you can still max out like your $19,000. And as an employer, you can actually make a matching contribution under certain rules up to a certain amount.
But it’s a way to double dip even though you may still be acting as a lone individual.
And depending on your brokerage firm, you may also have access to a Roth option for your solo 401k.
Most most brokerages have both the regular solo 401k option as well as a Roth solo 401k and the aggregate contribution maximum is the same as a regular 401k. It’s $56,000.
Actually On the HYW website, you can check out a step by step screenshot walkthrough I wrote. I wrote a post about solo 401ks on the HYW website blog. So feel free to check that out if you want more details.
I’ll include a link to that in the show notes as well. Then I want to talk about self directed 401ks.
These are like normal 401k is as well, except here, you have complete control over what you actually invest in.
You’re not restricted to only investing in funds that are offered by your 401k plan. You can actually self direct the investment strategy, hence the term self directed 401k.
So you can invest in alternative assets like you can buy real estate directly, not like a real estate fund, you can actually go buy the physical property with your 401k money.
You could buy precious metals directly.
You could buy cryptocurrency, you could buy promissory debt notes or tax liens or illiquid LLC shares.
Whatever you want, you can invest in with a self directed 401k and it gives you more freedom if you know exactly what you’re doing.
This is definitely not for beginners. But if you know exactly what you want to invest in, you can do that.
Myth and legend has it that Mitt Romney, former presidential candidate, and former leader of a big fancy private equity firm, Bain Capital, had a self directed retirement account, a self directed Roth IRA, but the principle is the same you’re self directing your investments and used that money to invest in companies he was in was already looking to buy and sell as part of his job.
And so legend has it that his Roth IRA is like $100 million, which would not be mathematically possible if you were just investing in regular stocks, through a plain vanilla Roth IRA.
And so if you really do know what you’re doing a self directed option could be very lucrative.
The IRS also has a list of things that are not allowed to be invested in with a self directed retirement account like self directed 401k.
So you are not allowed to invest in, for example, collectibles or antiques or art or rugs or stamps or things of that nature. Just can’t do it.
So for more details on that just Google the list of things the IRS does not allow you to invest in.
The key thing I want you to keep in mind is that the self directed option is not specifically about a particular type of 401k.
It just is a type of retirement account. So you can have a self directed 401k, a self directed solo 401k, self directed IRA, self directed Roth IRA, etc, etc.
The self directed part just means you are stewarding your own investments.
Now, you’re still going to need a custodian or some trustee that has to be named as the administrator.
You can’t literally just like keep the money stashed away in your drawers.
So usually that’s going to mean some kind of brokerage firm is administering the account.
And since you’re likely going to be dealing with alternative or fairly illiquid investments that are hard to value, that’s the reason why many brokerage firms don’t actually allow a self directed option because it’s not super cost effective for them to manage those.
So, as a practical matter, what will happen is that you’ll have a specialty firm that specializes in self directed retirement plans, who then goes and partners with big brokerages like Fidelity or Schwab or Etrade, or Wells Fargo to allow you to contribute money into the big brokerage and then the specialty firm handles like all your plan paperwork.
So that’s, roughly the mechanics of how that works.
Next account I want to talk about is the 403b plan. So I mentioned this a moment ago.
This is basically a tax sheltered annuity plan that operates very similarly to a 401k. But the basic difference is that 403b plans are used by public schools and tax exempt organizations like nonprofits or religious organizations, some government organizations as well for their employees.
These are generally organizations that are exempt from some of the administrative work that applies to 401k plans so the costs are lower because those employees tend to not make as much money.
And this helps their organizations which typically have small budgets to help their employees save for retirement.
But all the rules around contribution limits and tax deferral and withdrawal ages and stuff like that. That’s all pretty much the same.
Then we have 457 plans and these are plans offered by state and local governments and some nonprofits as well. And these are only employers who are exempt from paying federal income taxes, and non church organizations who can offer these type of plans so you know, specifically state and local governments, hospitals, educational organizations, charitable organizations, trade associations, things like that.
And again, the rules work largely the same as a 401k in terms of contribution limits and catch up contributions, required minimum distributions, but there are some things you should know about 457s.
One of the really important ones is that if your employer offers both a 401k plan and a 457 plan, or they offer a 403b plan and a 457 plan, then you can contribute to both the 457 and one of the other available retirement account.
So you could then also contribute to a 401k or 403b plan and you can max out the limit on each account.
So that means you can contribute $19,000 to your 457 plan and then contribute another $19,000 to your 401k or 403b plan.
Now, you have to make enough money to be able to contribute that much. But that’s really interesting because it basically allows you to double dip in a way that most other people cannot.
Also, unlike your 401k, or 403b plans, you can actually withdraw money from your 457 without any penalties before you’re 59 and a half.
That’s a really important distinction, because the tax implications and the flexibility you have with your money is essentially a lot bigger, a lot more with a 457 plan.
But you also need to know that if you then later roll your 457 money into an IRA, because maybe you leave that job or whatever reason, you just want to roll it out, you will lose the ability to cash out and withdraw that money early while avoiding a penalty.
You may be trying to do some type of Roth conversion thing. Maybe that’s the motivating reason why you roll that money out.
But just know that once you move that money out to an IRA, it loses the characteristics of being able to be withdrawn without any tax penalty.
So that’s one reason why it may be attractive to leave money in a 457 because you can withdraw penalty free.
Now, obviously, you’re still going to have to pay ordinary income taxes on those withdrawals, no matter the age that you withdraw from a 457. But at least there’s no early penalty.
Okay, so then, let’s talk about IRAs.
IRAs, or investment retirement accounts, and their Roth siblings have a lot of similarities to 401ks in terms of tax deferral and withdrawal ages and brokerages that offer it.
But the key difference is that IRAs are not offered by employers.
Anybody can walk in off the street and sign up for an IRA with a brokerage, regardless of whether you’re employed or not.
But the contribution limits are a lot lower than 401ks and there are also income threshold limits where if your income exceeds a certain level, then you’re going to get phased out of your ability to contribute to an IRA.
And eventually, if your income is like fairly high, then you won’t be able to contribute at all.
An IRA is a consumer retail product, a 401k is an enterprise product.
So, you might think, why would you ever invest in an IRA if the 401k you get from your employer is so much better, it has higher contribution limits, there aren’t any income limits, stuff like that.
And the main reason why people do it is because the investment selection is wider.
You can invest in any stock in an IRA, any bond, any option, future, whatever investments that your brokerage offers, you can invest in with an IRA.
Whereas a 401k is typically going to be limited to specific funds like target retirement date funds, or thematic funds provided in the plan which were negotiated by your employer.
There usually aren’t going to be more than a couple dozen investment options in a 401k. Whereas there will be thousands, even 10s of thousands of investment options in an IRA.
Finally, I’ll just briefly mentioned 401a plans, which are retirement plans that are normally offered by government agencies and educational institutions, some nonprofits as well, whereas 401k plans are only offered by private sector employers.
And one of the key distinctions is that while participating in a 401k plan is not mandatory, you certainly don’t have to do it, you don’t have to make contributions if you don’t want to, for the 401a plan, it often is mandatory.
The employer will often stipulate the terms and amount that you have to actually contribute. Whereas a 401k plan, the employee decides how much they want to contribute if at all.
Okay, let’s talk really briefly about rollovers.
When you leave a job or you quit or you’re fired, you can rollover your 401k to your next employer’s 401k plan or roll it over to an IRA.
Either way, the rollover rules are the same, whichever option you choose.
And you can do it one of two ways: you can do a direct rollover, where the money is sent straight from your old 401k to your new account, without you ever touching the money, and that won’t have any tax implications. There’s no tax consequences to that.
You can also have a check made out to you personally and then you go then turn around and deposit it into your new 401k or IRA account.
But here you have to be careful because once that money is distributed to you, you have to complete that rollover within 60 days from the day you receive the check to get it deposited into the new account.
Otherwise, the IRS is going to consider that a taxable distribution. And if you’re under 59 and a half, you’re going to not only going to have to pay ordinary tax rates on the distribution, you’re also going to have to pay that 10% penalty on the entire distribution amount.
So just something to be aware of.
When it comes to 401k loans, the maximum amount you can borrow from your 401k is generally going to be 50% of your balance or $50,000, whichever is less.
There has to be a written loan agreement. You can’t just take the money out, and you have to pay back a commercially reasonable interest rate. That interest rate it again, just gets paid right back into your 401k account.
So you’re basically paying interest to yourself. But to make it a bona fide loan, you actually have to pay a commercially reasonable rate. And as I mentioned earlier, the loan must be repaid within five years.
But there’s one exception to that, which is, if you’re using the money to buy a primary residence, then you have up to 10 years to pay back the loan with interest.
Some people wonder whether taking out a 401k loan could affect your ability to get a mortgage or affect your credit score.
Since a 401k loan isn’t technically debt, you’re withdrawing your own money, it has no effect on your debt to income ratio or your credit score, which are the two big factors that influence mortgage lenders.
So that part you don’t have to worry about. It doesn’t ever show up on your credit report. Again, because it’s not considered debt.
Most lenders will not also also will not consider a debt when calculating your debt to income ratio.
So why would you borrow money from a 401k?
Well, there’s several reasons.
One is that your interest rate on a 401k loan might actually be lower than what you can get from a bank or a line of credit or a credit card, and therefore it might be more affordable.
There are also generally no qualifying requirements for taking out a 401k loan. So if you don’t qualify for a commercial loan, based on say your credit history, then borrowing from your 401k might actually be a viable option.
The 401k loan process, the application process is actually also easier and faster than taking out a loan from a bank.
And it doesn’t go on your credit report.
And finally, loan payments are generally just deducted straight from your paycheck, which makes repayment easy and consistent.
But some of the downsides of taking your loan out from your 401k are that you could be missing out on investment growth because the money you borrow obviously is not going to be invested in anything else until you pay it back.
And furthermore, if you cannot repay that loan back then now you’re in violation of your loan agreement, which means you now you’re subject to the 10% penalty on any amounts you haven’t paid back.
And then also, one thing that can trip people up is that if you quit or you’re fired from your job, you might be required to pay back your loan within 60 days or else forced to take it as a hardship withdraw, which means now you’re paying taxes and penalties on top.
Let’s talk a little bit about beneficiaries now.
So, if you’re married, federal law says that your spouse is automatically the beneficiary of your 401k account.
And you should still fill out the beneficiary form, put your spouse’s name for the record, but by default, your spouse is going to be the beneficiary.
If you want to name a beneficiary, other than your spouse, then your spouse actually has to sign a waiver agreeing to that.
If you are single, when you die, then your account is going to go to whoever you list as a beneficiary.
But if you haven’t named anyone as a beneficiary, then the account is going to go to your estate.
Again, this is the case where you are single, whereas if you’re married, it automatically goes to your spouse.
If you name someone as a beneficiary when you’re single, then once you marry or remarry, then your spouse is automatically going to take precedence over your originally named beneficiary. Again, unless your spouse signs a waiver, agreeing otherwise.
Beneficiary designations you should know also override whatever is written in your will. That’s important.
Basically, your retirement account beneficiaries take precedence.
And finally you should know that children who are still minors cannot inherit as direct beneficiaries. They’re going to need some type of trustee to help them manage the money until they reach majority age.
Then we get to how 401k is interact with creditors.
And this part is really important because 401k are actually protected in bankruptcy.
Creditors can’t touch them. Bankruptcy proceedings can’t get that money either.
The government does not allow private creditors to access regardless any assets from your 401k because it falls under a law called the employment Retirement Income Security Act of 1974 or ERISA.
And that’s true even if you file for bankruptcy.
So it doesn’t matter how much money is in the account. As long as that money stays in your 401k, then private creditors can never get to it even if you declare bankruptcy.
But key point, once you withdraw the money, then that money has changed character. And then private creditors can go after it.
So it’s protected as long as it sits inside the 401k account. But if you withdraw money, then creditors can come after it.
But the protection from private creditors does not extend to the government.
Nothing’s ever that easy. The government itself does have the power to garnish your 401k money under some conditions.
One is when you owe back taxes or penalties to the government.
Another as if you’re in arrears to your spouse for alimony or child support.
So in those situations, the courts can actually, you know, access your 401k money and garnish it.
Now, when it comes to other types of accounts, like IRAs, or SEPs, simplified employee pension plans, 403b plans and even solo 401ks, these do not get the type of protections that the classic 401ks get because they are not governed by ERISA.
Sometimes state law protects these accounts in an ERISA like way, but they do not get federal protection under the big ERISA law.
IRAs are which are not covered by ERISA do have their own legal protections, though, for the first $1 million in an IRA account.
But to get that protection, you have to file for bankruptcy first, that’s important, whereas for 401k you don’t have to file for bankruptcy. So, you could be just going about normally and still creditors cannot get it.
But with an IRA to get that $1 million protection, you have to actually file for bankruptcy and that obviously is going to impact your credit score, etc.
Now let’s talk a little bit about how 401ks interact with other types of benefits.
So one common question, for example, is will 401ks affect social security benefits?
And the answer is, withdrawals from your 401k do not impact your monthly Social Security benefits since 401k withdrawals are considered non wage income.
And naturally since your Social Security benefits increase when you delay retirement by year, it actually can be beneficial to rely on your 401k distributions in your early years of retirement so that you can maybe postpone drawing from Social Security and thereby get higher social security payment later in return for that delay.
In terms of unemployment benefits, tapping into your 401k is just like spending your own savings. Unemployment benefits are not based on your net worth.
They’re basically an insurance against unemployment.
So even though you may incur some tax obligations by withdrawing from a 401k, it is not generally going to affect your ability to get unemployment benefits.
There are some exceptions to that.
Like in Massachusetts, your employment benefits could get offset a little bit by 401k withdrawals.
You should check your state rules, but generally speaking, unemployment benefits will not be affected.
One common concern that parents especially have is whether 401k contributions get counted for financial aid purposes for their kids.
Now, money in qualified retirement plans like 401ks 403bs IRAs SEP SIMPLEs Keogh plans, and some types of annuities.
All of these are not reported as assets on a FAFSA application, but voluntary contributions to these retirement plans during the what’s called the base year, which is the prior tax year, the prior tax year being the year before you actually filled out the FAFSA application.
In that year, the contributions are going to be counted as untaxed income.
That’s just something to keep in mind.
Employer matching contributions are not reported at all to FAFSA.
But untaxed income is going to have the same effect on likely reducing your financial aid eligibility as regular taxable income would.
And then finally, non elective contributions like mandatory teacher contributions to a State Retirement System where you didn’t have any choice one way or the other, those are not reported on the FAFSA application and are not considered and any needs type of analysis.
Lastly, let’s talk a little bit about what happens to a 401k account when you get divorced.
Here the rules are going to differ state by state, most states will do a 50/50 split.
And in those cases, you’d either literally split the assets through withdrawal or rollover half the money to a spouse’s retirement account, or an IRA, or one person would keep the entire 401k but then compensate for it by the spouse taking, you know, other marital assets of similar value.
The only thing you shouldn’t do if you’re getting a divorce, if you’re in the process of a divorce, is just to start transferring or withdrawing 401k money out.
That’s a big no-no, you need a court order to actually divide a 401k.
Pulling money out of a 401k is not something you can just do on a whim. A court judge has to sign a domestic relations order, which confirms that each spouse has the right to a certain portion of the money.
And that order spells out exactly how much like a dollar amount or percentage that each spouse is getting.
And that court order is also important for the person who actually then retains the account after the divorce because it gets you off the hook from having to pay taxes, or an early withdrawal penalty on any money that was taken out from the plan.
Well, that’s a wrap.
I know this was a really dense information packed episode.
Again, I summarize this framework into a helpful free cheat sheet so you can have it as quick reference later, you can grab that freebie by going to the show notes for this episode hackyourwealth.com/3. And just to summarize again what we covered, we talked about the origins of the 401k, how contributions, tax deferral, withdrawal rules work.
We talked about required minimum distributions, as well as specialty topics like rollovers, loans, beneficiaries, creditors, etc.
So hopefully that gives you a good grasp on all the major rules around how 401ks work.
Again, grab that freebie for this episode hackyourwealth.com/3.
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All right. Thanks for tuning in.
Next week, I’m going to do a deep dive and talk all about IRAs and Roth IRA strategies and how you should think about them interacting with 401ks.
Again, it won’t be a beginners episode, we’re going to dive into some advanced topics.
And so you won’t want to miss that.
You’ll learn some techniques on how to supercharge your wealth building and minimize or even eliminate taxes entirely by doing a laddering strategy.
So be sure not to miss that and we’ll see you next time.