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What is a 401(k)?

The 401(k) plan allows you to take an active seat in planning for your financial future. By making regular investments over a long period the 401(k) allows you to keep an active lifestyle in your retirement years.

A brief history of the 401(k)

In the late 70’s, a pension consultant named R. Theodore Benna, saw an opportunity within the subsections of the Revenue Act of 1978 to ensure that regular employees could enjoy the same benefits of retirement plans as high earning executives.

The subsection of The Revenue Act, Code 401(k), provided a federal directive to ensure that any bonuses for the employees could either be received in cash or placed in a savings plan that would allow them to defer paying taxes until a withdrawal was made on those savings.

Benna, had the brilliant foresight to extend the language of the code to employee’s regular earnings, instead of narrowly focusing on the intermittent bonuses and brought his argument before the Internal Revenue Service. The IRS recognized the value of allowing the American working population to have greater control over their financial future, thereby reducing the heavy dependence on social security and company pension plans.

This initial collaborative effort between the government and private sector led to the 401(k) plan as we know it today.

Taking Control with the 401(k)

Our financial future is in our hands. We can no longer plan on a company pension or Social Security check to take care of our needs as we get older and are no longer able to earn as we did in our youth. The good news is that you can learn the principles of how to manage a 401(k) plan and take command of your financial future.

How does a 401(k) Work?

1. Time

Time is the essential factor in investing for a 401(k) because it puts the power of compounding interest in the investor’s favor.
Compounding interest allows the principal amount, the dollar amount contributed to the plan minus fees, to grow at an exponential rate. The total length of time the principal amount invested is the exponent.

For example, $1000 invested at 10% interest would become $2,594 in 10 years, $6,728 in 20 years, and $17,449 in 30 years. This is how you make money work for you!

There are many online calculators out there you can use to play around with the investment period, interest rates, and monthly contributions. Here is one from a government site: compound interest calculator where you can plug in numbers of your own to see how it all works.

2. Regular contributions

The habit of making regular contributions is the second key element to having a strategic 401(k) plan.

The more contributions you make to the plan – the more money you’re putting into the compounding interest rate equation to be available for growth over time

Let’s use the example of the $1000 initially invested that we used earlier. Now we are going to add $100 every month on top of the initial investment while keeping the interest rate at 10%.

10 years – $1000 initial deposit, $100 monthly contributions at 10% interest rate: $21,719
20 years – $1000 initial deposit, $100 monthly contributions at 10% interest rate: $75,458
30 years – $1000 initial deposit, $100 monthly contributions at 10% interest rate: $214,842

As you can easily see, the return for your patience and solid saving habits is going to pay off big time for you in the long run, and you will have the money you need to enjoy your retirement.

Now we kept the interest rate fixed in our hypothetical perfect case scenario. This will not be the case in the real world, and you will experience years where the interest rate drops considerably and other years where the interest rate remains high. However, over the length of a 10-30 year investment, the fluctuations in the market will smooth out allowing a much higher rate of return than if the money stayed in a bank savings account.

3. Inflation

The power of cash diminishes over time. The spending power of a 1000 dollars today will not be equal to the spending power of a 1000 dollars 10 years from now. This is a result of inflation, and it is the primary adversary we are trying to beat in long-term investments.

The 401(k) plan is designed to fight the diminishing value of money by investing early and making regular contributions over an extended period. The rate of return over the lifetime of the investment will easily beat out the corrosive effects of inflation.

Putting money into the plan

401(k) plans work by allowing you to utilize a portion of your pre-tax income dollars as the seed capital for the investment. This amount can be deducted from the annual income thereby reducing tax burden during the higher earning period of your working years.

There is a ceiling for the amount of money that can be placed into account every year from your income, in 2018, this limit is $18,500, Source: Money.CNN.com The federal government sets the maximum contribution amount and increases the amount regularly to keep pace with inflation.

Many companies structure 401(k) plans to include employer match contributions as an additional incentive to attract and retain high-quality employees.

If you have this option, you should take advantage. Remember the power of regular monthly contributions and what it can do?

If we put down $1000 and contribute $100 monthly, for 30 years at a 10% interest rate, we walk away with a little less than $215, 000. Now, if the company kicks in an additional $.25 to your contribution dollars, then your monthly deposits jump to $125. Over 30 years this yields right around $264,000 – an astounding, $49,000 gain by allowing your employer to contribute to your plan.

Taking money out of the plan

The 401(k) is designed to be a retirement plan, and the government kicks in by allowing you to deposit money into the account with pre-tax dollars.

It, therefore, is reasonable that investors stay incentivized to stay in the plan for the long run. The IRS has placed restrictions on withdrawals of the money invested in a 401(k) account to penalize investors who change their minds about investing for the long run.

Any early withdrawals, before the age of 59 ½, is subject to a 10% penalty charge as well as counting towards your total income for that year.

The upside is that the plan recognizes certain life situations where investors need access to additional finances to help them get through tough times in their respective lives.

For example, the easiest way to take money out for an unexpected expenditure would be to take a loan from the total present value of the individual investor’s 401(k) amount. This loan would have to be re-payed before the age of 59 ½ and is subject to a loan interest rate – this can be a fixed rate or a variable rate and is based on the firm that is managing your account.

The plan also has a hardship withdrawal provision, which allows money to be taken out before the age of 59 ½ without having to pay the amount back into the plan, as is the case with a loan. However, specific requirements need to be met: money will be utilized for reducing college tuition debt, purchasing a home for the first time, medical expenses, and to prevent any type foreclosure or eviction from your home.

How to know the quality of your plan

According to, Money – 401(k) Take Charge Of Your Future by Eric Schoenberg, the hallmarks of a well laid out plan are the following key traits:

1. Allows investments up to 15% of your salary pretax

2. Your company matches your contributions up to 6% or higher of your salary

3. Money can be transferred among the different types of funds, a well-planned account should have 10 or more, on a daily basis

4. A well-diversified portfolio. For example, many Enron employees had a significantly higher investment in the company’s own stocks than in proportion to other market funds, therefore exposing themselves to very high risk in case the price of the company stock plummeted, and this is what finally occurred, with many losing their entire life savings. Don’t fall victim to this -diversify your accounts

5. The plan allows access to hardship withdrawals in and the loan payments have stated conditions for the loan interest rates and payback time requirements

Summary

A smart investor will start early and make use of the compounding interest over a long period. By playing the long game, the investor will reduce the worries of the value of the money in the present year, but instead, keep an eye out for the total sum of the money accumulated at retirement.

If you are someone that is not eligible for a 401(k) or would like to couple their 401(k) with an IRA account please see our article: IRA vs 401(k) – The Comparison

Tim Schmidt

A Florida-based Entrepreneur, Author, and Life Hacker, Tim Schmidt decided to take control of his retirement portfolio several years ago by setting up a self-directed IRA. This blog shares his thoughts and opinions on the top of retirement and investments. You can follow his career and travels on his Official Website as well as on his Instagram page.