83 – How to Setup a 401k


Episode Overview:

Moving on the next tool in your Net Worth arsenal, a 401k is an employer sponsored retirement plan. 401ks allow employers to make tax deductible contributions to an employee’s savings account. Ken discusses key attributes of this type of account including a contribution “match” and “vesting schedules.” Ken explains how to utilize these features to the fullest – as well as 401k limitations. Finally, he teaches you how to set one up.

Transcriptions are auto-generated, please excuse grammar/spelling!

Happy day to you. This is Ken Kaufman. And I’m thrilled you’re here for episode number 83, “How to Set Up a 401(k) Account.” Now, a 401(k) is an employer-sponsored retirement plan, and it is actually allowed under code section 401(k) of the Internal Revenue Code. So, I don’t know if you knew that. This concept of 401(k), it literally is part of the IRC or the Internal Revenue Code that allows an employer to sponsor this type of plan for its employees. And it’s referred, too, also as a defined contribution plan.
Now, in the context of this, an employer sets up this plan to allow employees to set money aside and save for, you know, preferably retirement. There can be other ways to access the money that we’ll talk about here in a second. And it allows the employer to also make tax deductible contributions into the plan for their employees. There’s a couple things to consider before we jump into the tactical parts of actually setting up a 401(k) at your employer.
The first one is, you need to consider the match. There’s a lot of talk in the financial planning world and even for, you know, those that are the do-it-yourself-ers about this concept of take advantage of the match. If you’re not getting the full match from your employer, you’re leaving money on the table. And within this concept, what it means is that some companies…not all. Some will sponsor 401(k) plan and they’ll allow their employees to contribute, but the employer does not put anything in. Many employers will contribute some amount if their employees are willing to participate.
For example, a common structure would be an employer who would say, “We will match, dollar for dollar, the first 4% of your salary that you put into the plan.” So, for example, if I made… I will just choose an easy number here. If I made $100,000 a year, if I put 4% into the plan, that would be $4,000, the employer would match that and put $4,000 in as well. So, that’s the concept of a match. Some people will say it’s free money, and that’s true. But remember, it’s costing you money in the sense of your taking money out of your paycheck and it is going into a retirement plan that can be sometimes very difficult and very costly to get access to. And so, you have to be ready and prepared to have this money come out of your cash flow. Now, I’m not trying to make 401(k) plan sound bad. Generally speaking, they’re very good. And I would highly encourage you to participate and to try to maximize the match that your employer is making available to you. Just be ready that your cash flow out of your paycheck will go down a little bit.
Next are vesting schedules. Generally speaking, employers will put a vesting schedule on the portion of the 401(k) account that the employer is contributing. The money that you put in is always yours. That’s 100% yours and if it goes up or down with how you invest it, wherever it’s at, if it comes to a place where you’re going to roll it over, you’re going to take it out, that is yours 100%. Employers will sometimes, to incentivize employees to stay with them longer, make contributions into the plan but put a vesting schedule on it that says, “Hey, if you leave me within the first year, you get none of it. If you leave me within the first two years, then you get 20% of it,” and then 40% and 60% and 80% until you get 100% of it. Other plans will have a straight 50-50 where if you’re there for a full two years, you would get to keep 50%, and then over two years, then you get 100%.
There are also what are called safe harbor plans where the employer has no vesting schedule whatsoever. And it doesn’t even have to be a safe harbor plan, but they just say, “Look. Whatever we, as the employer, put in for you, if you’re to leave tomorrow, you can take all of it regardless of how long you’ve been with the organization.” So, just be aware of what that vesting schedule is and how that works as you go into it.
And the third thing to make sure that you’re thinking about as you get into this process is, there are limits that you can…the amount of money that you can defer out of your check and put into an employer-sponsored 401(k) plan. In the year 2020, the annual limit is $19,500. So, that’s quite a bit. That’s a pretty big chunk. If we go back to that $100,000 a year person, that would be roughly 20% of their income for the year. So, that’s pretty high. And then there is also a catch-up provision like there are with IRAs where if you’re over 50, you can add an extra $6,500 to the $19,500 for a max contribution for a year of $26,000. That is pretty impressive if you’re really trying to catch up and get money put away for retirement, the ability to put $26,000 in is great. Better than an IRA if you went and created that where you can only put $6,000 away. Plus then if your employer’s matching, anyways, you can start to see the benefit and why this could be very, very beneficial.
So, knowing that, now let’s jump into the tactical element of how do you set this up. The first thing you need to do is you need to contact your HR department to get information about the plan. They should have a summary plan description. They should have a link to a website or a brochure of some sort that tells you about who the record keeper and custodian of the assets are in the plan, what investment options they offer you and all of those things. The other question to ask when you contact HR is find out if your employer does auto-enrollment. You may actually already have a 401(k) and there may actually be some money in it that the employer or perhaps even you’ve been auto-enrolled and there’s been money coming out of your paycheck and you didn’t notice it. So, find out from HR if you have auto-enrollment or not, if that account’s already set up and being funded, or if that’s not the case, then get the information about how to log into the website, whether it’s through your payroll provider or through the 401(k) provider, and get yourself all signed up so that you’re ready to go.
The second step. Once you get that online account set up and you get your information in and all that gets synced up with the help of your HR department, second thing is now you need to pick your deferral amount. How much do you want to come out of your check? Now, if you’ve been auto-enrolled and there’s been a certain amount already coming out of your check and you like that amount, then you can just leave it alone. You’re good and no need to make a change.
If you don’t like the amount or if you have not been enrolled or signed up, then you get to pick. You can pick a flat dollar amount and say, “Hey, I want $100 per check to come out,” or you can say, “I want a percentage to come out,” or if you know what the employer’s match is and you only want to put in the amount of money required to get the maximum amount of the match, then you would do that. Some employers will set their plans up so that you can get 50% of the first 6% that you defer. So, you defer 6% of your salary into the plan and they’ll put 3% in. So, it’s kind of like a 3% raise. This is completely up to you as to what you want the amount to come out of your paycheck to be.
Now, the next key decision to make is, do you want to contribute as a traditional IRA or…it’s just called traditional 401(k), or a Roth 401(k). So, here’s a really cool thing. With the advent of the Roth IRAs, 401(k) plans actually have the option where you can put your money in out of your paycheck to where it is not taxable income on your paycheck, and it goes into the traditional 401(k) account for you. If you don’t mind the money being deferred out of your paycheck after tax, meaning that the income has been taxed, that’s going to the 401(k) plan, your dollars can be deferred into a Roth option.
And just like my last episode on traditional versus Roth, the rules here are exactly the same. Both account types, the earnings grow tax deferred. The traditional IRA, the money going in is tax-deductible. So, it reduces your taxable income. But whenever you take the money out, then it is fully taxable to you at whatever tax brackets you’re in. The Roth IRA is the opposite. It is an after tax contribution. So, no tax deduction for whatever you put into the plan. And then when you take it out, it is fully tax-free, your distributions as long as you meet all of the requirements around that. You can go back to the last episode, which was episode 82 and you can take a listen to that if you have any other questions around that.
One key thing to make…or one key point to make here. Even if you elect to have your amount come out of your paycheck into the Roth 401(k) option, the employer portion is always in a traditional IRA or a traditional 401(k) setup. And what that means is, the employer’s putting the money in and they’re taking a tax deduction for doing it. That’s part of the incentive for employers to sponsor these types of plans and to contribute in behalf of their employees. Those funds cannot… You cannot tell your employer, “I want mine to go into a Roth option.” It is always that. And so, just know in your mind that the match you’re getting from the employer is traditional IRA and your money, if you’ve chosen Roth, that that’s in the Roth option.
And for those of you when you listen to my last episode, if you like the idea of having tax diversification amongst your assets, meaning some are taxable when they’re going to come out of retirement and some are going to be tax-free at retirement, this is an interesting strategy. Let your employer fund the taxable portion, meaning taxable when it comes out, and you can fund into the Roth IRA which means it’s tax-free and then that gives you some flexibility in retirement. If your tax bracket is high, you can choose to take from the Roth IRA. If your tax bracket is low, you can choose to take from the traditional 401(k) side of your balances.
Now, the next thing that you’ve got to do once you decide if you’re Roth or traditional and you’ve picked your deferral amount, is the hardest part. And this is where people start to drop off. I see this in my current employer. We have hundreds of employees and we see where people stall out the most frequently is when it’s time to pick the investment option, they don’t finish. They get nervous, scared, intimidated sometimes by all the numbers and investment choices. And so, what I would encourage you to do, like I did a couple of episodes ago, is pick the retirement date fund, the one that is closest to when you think you might retire. Start there and then either get a planner, somebody who’s a professional who can help advise you on where to invest. And by the way, your HR department can’t tell you where to. They’re not finance professionals or financial planners or investment experts. And so, you want to be careful about taking advice from them.
But start yourself in the target date fund and then either spend the time that you need to, to become a do-it-yourself-er investor or get some advice so you know how to move forward. But please don’t stall out. Pick that retirement date fund for now, or if you’re even really conservative, you can pick the stable value or money market fund, which is earning almost nothing in interest here as we sit in October of 2020. But at least you can get in the process of starting to put the money away. And again, I’m not offering investment advice in any way. I’m not licensed to and I don’t know your personal situation at all. Just encouraging you to not stall out here. Find an option and then if you still feel uncomfortable, you can get some professional advice and then it’s very easy to log back in to your 401(k) account and make changes.
Now, just a couple more things as I wrap this up. When it’s time to get money out, there are rules that you have to follow. If you have some type of a hardship, you might qualify to be able to take some money out and avoid penalties because generally speaking, if you try to take this money before your aged 59.5, there could be taxes and penalties that could come your way and really erode the value of the money that you’re taking out of the plan. So, it’s preferred to not take this out, but you might qualify for some type of a hardship withdrawal that may have the opportunity to waive some of the taxes or fees, depending on the circumstance and your plan and everything that goes with it. So, that’s an option.
Another one is many plans have loan provisions, which means you can actually borrow money from yourself and then pay yourself back with interest. The logic is, it’s better than going to back because you’re going to pay the interest to the bank. In this scenario, you’re just paying the interest to yourself. There are some real downsides to this, like, if you pull the money out for a loan and the market goes way up, your money wouldn’t have been invested in the market and you would have missed those potential returns. Anyways, there’s risk associated with that option as well. But just know there are some potential ways to get it out. But if you’re really trying to have the long-term view and picture here, this is money that you should be earmarking for retirement and have emergency funds and other things around you so that you would not have to resort to taking this money out unless it was truly a serious and significant hardship.
Now, the last piece is, if you ever leave your employer, what then happens? Depending on how big your balance is, your employer may be obligated to keep that balance there. And you can continue to log into your 401(k) account and make changes, but you wouldn’t be contributing to that employer’s plan anymore. Most financial professionals, unless, you know, they look and see that the investment choices you have are just so amazingly superb and the cost for you to be in this 401(k) plan are so low and reasonable compared to other options in the marketplace, most financial professionals would tell you when you leave your employer, “Go ahead and roll your 401(k) over into another company where you can have more control, usually more investment choices and options.” And often, you can do so for free or for very little cost.
In today’s day and age, online brokers, the Vanguards, Fidelitys, M1 Finances of the world have low cost to almost zero cost options that sometimes 401(k) plans cannot compete with. Generally speaking, it’s smart to really seriously consider rolling your IRA over to another institution, which is totally allowed, totally legal. People do that all the time when they change employers. One other thing that sometimes employees will do… And, you know, there can be some benefits as well, some setbacks to this, but you can also roll your 401(k) from your old company to the new company where you began working. And you can put that money into that plan and then continue to contribute out of your paycheck at that employer.
Something to think about. Something to consider. And on the topic of this rollover IRA, I will actually cover that in my next episode: how to set up a rollover IRA, what the rules are, and how all of that works. I hope this has been helpful. Many, many thanks to you for joining today. This is a wrap for episode 83. Happy day.

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About the Podcast

Join Chief Financial Officer Ken Kaufman as he helps you track and hack your net worth. For those seeking financial independence, your net worth is one of the most significant measurements of success. Using his two decades of financial experience, Ken Kaufman helps you overcome your financial obstacles and look onward towards a better, brighter financial future.


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