401(k)s: Five Terms You Should Know

I was recently having a conversation with a client about their 401(k), a few minutes into the conversation I realized that I had lost her attention. I realized that I had started using financial jargon and that was where she stopped tracking the conversation. That’s when I decided to re-direct the conversation and spend some time talking through a few of the key terms associated with employer retirement plans.

If you have a 401(k) here are some of the terms you should be familiar with. Having a strong understanding of these concepts will ensure you are making the most of this incredible employer benefit.

Contribution Percentage

One of the first questions you will be asked when enrolling in employer 401(k) will be ‘how much do you want to contribute?”. You will have the option to contribute a flat dollar amount or a percentage of income. Which is the best option to choose?

I am a big fan of defining a contribution percentage which is a fixed percentage of income.. For example, if you’re making $50,000/year and make the decision to contribute 10% of your income, you’ve committed to saving $5,000/year into this account.

There is nothing wrong with a flat dollar amount but there is a benefit to choosing the percentage of income route. By committing to a contribution percentage, your contributions will automatically increase as your income increases over time and receive bonuses over the course of your career.

Determining the right amount to contribute to your 401(k) is dependent on your financial situation and other financial obligations. If the goal is to one day reach financial freedom (i.e. retirement) a good rule of thumb is to save at least 10% of income. I like to challenge my clients to start at 10% and work their way towards the maximum contributions by upping their contribution percentage each year. In 2019, the maximum contribution amount is $19,000/year.

Employer Match

An employer match is common in most 401(k) plans. If you are one of the lucky ones with an employer match then you are eligible for FREE MONEY from your employer. Yes, you heard my correctly, free money.

Essentially, employers are rewarded with tax deductions to make contributions into an employee’s 401(k) on their behalf. A common employer matching provision is up 4% of the employer’s income. Using the same example above, if you as the employee are making $50,000 per year and contributing 10% per year, you would be eligible to receive a 4% contribution by the employer or $2,000/year for a total annual contribution of $12,000 ($10,000 employee contribution + $2,000 employer contribution).

If you were that same employee making $50,000 but only decided to contribute 2% of your income towards the 401(k), then your employer would only match you up to 2% or $1,000/year. The lesson being, if your employer is willing to match 4% of your income, you should be contributing at least that amount if not more. If you are like the employee only contributing 2%, you are leaving another 2% ($1,000) of money on the table.

Vesting Schedule

A vesting schedule refers to the amount of time that must pass before you own the entire value of the asset. Vesting schedules are also used with stock options and restricted stock units (RSUs) but for the purposes of this post, we are going to focus on vesting in the context of a 401(k) retirement plan. The vesting schedule only applies to the employer contributions. The contributions put in by you, the employee, are immediately or 100% vested.

There are typically two types of vesting schedules; cliff or graded vesting.

  • Cliff Vesting – employer contributions are 100% vested after a certain period of time has passed. As a example, if your company has a three year cliff vesting schedule, after three years with the employer, those contributions are 100% vested.
  • Graded Vesting – employer contributions are gradually vested over several years. As an example, if the company has a six year vesting schedule, the employer benefits would vest a greater percentage of the account value each year leading up to year six. An example of a graded vesting schedule is below.

I stress the importance of knowing your company’s vesting schedule, especially if you plan to switch jobs in the future. Before giving your two week’s notice, it’s important to understand where you are in the vesting schedule. It might be worth working the extra six months to reach the company’s cliff schedule or gain an extra 20% of vesting.

Tax-Deferred vs. Pre-Tax

The majority of 401(k) plan offer a pre-tax or Roth option in addition to the traditional tax-deferred 401(k) environment. If you are one of the lucky few with an after-tax option, pay attention!

Traditionally, 401(k) contributions are pre-tax, meaning you as a taxpayer receive a tax deduction on the contribution today in exchange for tax-deferred growth and taxable distributions in retirement. Pre-tax contributions are great for high incomer earners actively looking for ways to save on taxes today. For the purposes of this conversation, I will define a high income earner as someone in a marginal tax bracket that begins with a three (i.e 32%-37% tax bracket).

If you aren’t a high income earner, I would consider making after-tax contributions to your 401(k). With after-tax contributions, taxes are paid on the contributions made today (no tax deduction) and grow tax deferred. The best part of a pre-tax contribution is that because taxes were assessed when the contributions was made, distributions from the Roth portion of the 401(k) are tax FREE! In the words of my college retirement planning professor, short term pain for long term gain.

If you find yourself in the early part of your career or not yet in your peak income earning years, I would strongly consider making after-tax contributions if available to you. With this strategy you are betting on the fact that your marginal tax bracket will be at a lower rate today than it will in the future and in your retirement years.

Target Date Funds

When it comes to investment options, you will likely be presented with a list of 15 to 20 investment options that will range from large cap growth funds to stable index funds. What does this mean and what funds should you pay attention to?

A final term that you should be familiar with as a 401(k) participant is a target date fund. Every 401(k) plan will have a lineup of four to five target dates funds to choose from. They stand out from the other mutual fund options because they have a future date in the title. An example of a retirement date fund is the Vanguard Target Retirement 2055 Fund.

The beauty of a target date fund is that its a dynamic investment strategy that shifts overtime to match the investor’s timeline until retirement. To break it down another level, young investors decades from retirement are better suited with a more aggressive investment strategy. An aggressive investment strategy is one with a greater focus in equities over fixed income. As you begin to approach your retirement years, its more advantageous for that investor to have a more conservative investment strategy with a greater focus on fixed income over equities. With a target date funds, these changes are made automatically as the target retirement date approaches.

A rule of thumb when picking a target date funds it to take your year of birth and add 65 (future retirement age) and pick the target date fund that’s closest to that date. To use myself as an example, 1991 + 65 = 2056 which means I should be looking for a retirement date fund with 2055 or 2060 target date.

Ask for Help

I will wrap up this post as I’ve done in the past and remind you all that it’s okay to ask for help. Hopefully the list of terms above will help you decode your 401(k). If you find yourself in a situation where you’re unsure of a term, ask for help! The answer is a Google search or email to your favorite Financial Fashion Planner away 🙂