By Aaron Sherman, staff writer for The Dime
As we *hopefully* established in the inaugural post for February’s month-long blog series, a 401(k) is an integral “leg” of many peoples’ retirement stool (curious where the heck we’re going with this furniture metaphor? Click here). The retirement savings option has been so widely adopted, we’d be willing to bet that you and/or someone you know has access to a 401(k) account via your and/or his/her employer. But are you unsure what a 401(k) actually is? Don’t worry, we’ve got you.
Learning a new concept can be tough at first. So, to make it a little easier, let’s take a look at this 401(k) business through a lens/product you’re probably already intimately familiar with: a savings account.
Short-term vs. Long-term
While a savings account is primarily for short-term savings goals—think an emergency fund (gotta have that), a vacation fund (definitely gotta have that), etc., a 401(k) is for long-term savings goals—namely retirement. As you might expect, each has its own rules and costs associated—which, lucky you, we’ve explained below.
The money sitting in your savings account has already been taxed by the state and federal government. So, you don’t have to pay taxes on that money (unless you earn interest on it, in which case you do. Yes, we get that this is somewhat confusing—bear with us). To entice people to want to save for retirement, on the other hand, the powers that be knew that there would have to be some sort of incentive associated with the 401(k). That’s why you’ll notice that funds you put into your 401(k) account are tax-deferred, meaning that they aren’t subject to taxes (initially, anyway). Contributing these tax-deferred funds to your 401(k) also lowers your taxable income, and, lower income = lower taxes. To put numbers to it, let’s say you earn $35,000 annually, and put $5,000 over the course of the year into your 401(k). You would actually only end up paying taxes on the $30,000 of your income that you take home.
But here’s the (slight) catch: When you take $100 out of your savings account, you’re not taxed on the money because you were already taxed on it back when you were paid the $100 by your employer. When you take money out of your 401(k), however, you will pay taxes on the amount withdrawn since, you’ll recall, the initial contributions to your 401(k) were tax-deferred—you didn’t pay taxes on them upfront. So, the moral of the story is that Uncle Sam always ends up getting you in the end…it’s just a question of whether he gets you now (savings account) or later (401(k) account).
Interest vs. Return
With a savings account, your bank promises to pay you interest on the money you put in—perhaps 1% or more, if it’s particularly generous. Any money you have with your bank is also FDIC-insured up to $250,000, which basically means that the U.S. government promises to issue an IOU should your bank happen to fail, be robbed, etc.
In a 401(k), meanwhile, there are no guarantees or promises. The money in your account is not FDIC-insured, nor do you earn a set percent of interest on it. Instead, you earn what's known as “returns.” Allow us to explain.
Let’s say you contribute $100 to your 401(k) on January 1, and decide to use that money to buy stock in a company. If that company ends up performing well and keeping its investors (like you) happy, its stock value will typically increase. If that increase in this scenario equates to, say, 7% over the course of the year, you’ll have earned a positive 7% return on your $100 (or $7). If, however, the opposite happens—the company doesn’t perform well and its stock ends up losing value—you’d be subject to a negative return. This up-and-down flip-flopping that’s just a natural part of the stock market is what makes the 401(k) as a savings vehicle less secure than a defined benefit plan, for example. However, it’s also what gives individuals who choose to invest in a 401(k) the opportunity to earn more on their retirement savings than they would in a run-of-the-mill savings account. Over the long-term—we’re talking decades here—people do tend to earn more than the sum amount of what they actually contribute.
Are you surprised? Yep, inevitably there are fees associated with managing your money; after all, there are salaries to pay, office lights to keep on, reams of paper to purchase. These sorts of necessary evils are often times easier to pin down for a savings account—for example, you’ve got the ATM withdrawal fees and monthly account maintenance fees, to name a few. With a 401(k), there are just as many—if not more—opportunities to charge fees. The company managing the 401(k) needs to be paid. The stocks and bonds you purchase when contributing money have fees associated with them. There are sometimes withdrawal fees, as well as fees for borrowing from your 401(k) before you’re eligible for retirement. There can even be monthly and annual fees. If you currently have access to and/or are contributing to a 401(k) through your employer, it’s a good idea to familiarize yourself with your individual account’s fee structure. After all, they say that knowledge is power, right?