Welcome, Dukes! You have successfully completed the foundation of your kingdom. Now that the concrete has completed cured, we move on to our kingdom’s walls.

Our wall design documents have two action items: 401(k)’s and emergency funds. Before we begin talking through our first action item, please refill your water from the well, sharpen your tools on the wet stone, and bring the ladders from storage. Ready? Let us go about these walls!

This post is part one of three in the 401(k) Series:

  1. Deciphering the Traditional 401(k)
  2. Do you like free 401(k) contribution money?
  3. Choosing funds for your 401(k)

Deciphering the Traditional 401(k) Plan:

Retirement Plan History:

Before 1978, employers managed employees’ retirement plans through pension plans. These defined benefit plans, guarantee income from the employer in retirement, placing the risk with the employer to fulfill that guarantee.  If a company declares bankruptcy or the pension plan doesn’t perform well, then a retiree’s income is in jeopardy.This increased risk and higher cost on the employer gave way to a new plan, called the 401(k) in 1978.

The new plan makes it easier for knowledge workers to switch plans when changing employers, easier for smaller companies to offer to their employees (because of lower cost) and put control in their employee’s hand. Many people may argue that the defined benefit plans conveyed a higher degree of employer contribution and safety for the employee, but we at Duke of Dollars believe in taking matters into your own hands, and the 401(k) gives you quite a bit of control and flexibility.

Traditional 401(k)s Deciphered:

What is a Traditional 401(k)?

A traditional 401K is a qualified investment account into which employees can make pre-tax and taxable contributions from automatic paycheck deductions. Pre-tax contribution means that we do not pay federal or (usually) state income tax on the amount contributed.

Typically, employers (sometimes automatically enrolling) allow you to make a contribution based on a percentage of your salary, that they will then deduct each paycheck.

What is my limit for contributions?

$18,500 – In 2018, we can contribute 18.5G’s of pre-tax investment dollars into a 401(k) if you’re under 50.

$24,500 – In 2018, we can contribute 24.5G’s of pre-tax investment dollars into a 401(k) if you’re 50 and older.

Employer Contributions

Employers contribute to your 401(k) through matching – AKA free money!!

Many employers incentivize their employee’s to save for retirement by offering what they call a match.

For example, they may match 0.5% for each 1% percent you contribute, up to 6%. This means, if you were to contribute 6%, your employer adds 3% to a total of 9% that year. These are not included in the 18.5K limit we as individuals have!

In our second post of the 401(k) series, we will demonstrate why taking advantage of this free money will give you a boost to your financial kingdom timeline.

Vesting

Employers typically enact investing schedules to receive their free contribution amounts. They may require you to work at the company for 3 years to become vested, meaning if you leave before 3 years, then they will be taking the matched contributions back. After 3 years, the money is all yours.

Withdrawing from your 401(k)

Straight from the IRS:

“Generally, distributions of elective deferrals cannot be made until one of the following occurs:

  • You die, become disabled, or otherwise have a severance from employment.
  • The plan terminates and no successor defined contribution plan is established or maintained by the employer.
  • You reach age 59½ or incur a financial hardship.

Tax on early distributions. If a distribution is made to you under the plan before you reach age 59½, you may have to pay a 10% additional tax on the distribution. This tax applies to the amount received that you must include in income.

Exceptions. The 10% tax will not apply if distributions before age 59 ½ are made in any of the following circumstances:

  • Made to a beneficiary (or to the estate of the participant) on or after the death of the participant,
  • Made because the participant has a qualifying disability,
  • Made as part of a series of substantially equal periodic payments beginning after separation from service and made at least annually for the life or life expectancy of the participant or the joint lives or life expectancies of the participant and his or her designated beneficiary. (The payments under this exception, except in the case of death or disability, must continue for at least 5 years or until the employee reaches age 59½, whichever is the longer period.),
  • Made to a participant after separation from service if the separation occurred during or after the calendar year in which the participant reached age 55,
  • Made to an alternate payee under a qualified domestic relations order (QDRO),
  • Made to a participant for medical care up to the amount allowable as a medical expense deduction (determined without regard to whether the participant itemizes deductions),
  • Timely made to reduce excess contributions,
  • Timely made to reduce excess employee or matching employer contributions,
  • Timely made to reduce excess elective deferrals, or
  • Made because of an IRS levy on the plan.
  • Made on account of certain disasters for which IRS relief has been granted.”

Borrowing from your 401(k):

Generally speaking, we do not advise borrowing from your 401(k) and will not be going into details on how in this article.

There are some situations where a 401(k) loan is a logical choice for advanced Dukes, and we’ll dive deeper into those scenarios at a later date. In the meantime: if you need the cash badly enough to be considering a 401(k) loan, please contact us and we can give input on your situation :).

Why utilize 401(k) plans?

Three main reasons:

  1. Pre-tax contribution = decreasing your tax bill!
    1. We will go into more detail in post 2 on how your contributions can change your tax bill
  2. Pre-tax contributions = more money invested
    1. Since we are not paying any federal income tax on the money we contribute, this means we can take advantage of compound interest on more money. More money equals higher returns and a bigger nest egg!
    2. In post two, we will be charting out the advantages for growing your money at a faster rate!
  3. In our retirement, we assume a lower tax bracket compared to our working years. Because 401(k) withdrawals are taxable income, a low-income retirement allow us to hang on to more of our compounded dollars. Later on, we’ll review strategies for maximizing the value of tax-deferred investments.

Overall Comments:

At Duke of Dollars, we are huge fans of wielding the 401(k) tool in our kingdom toolbox. It allows us to increase our overall investment amount while saving on federal income taxes, and then withdraw that money when our tax bracket is lower, taking true advantage of the qualified plan in our reach.

For stop IV, we ask our Duke’s to contribute to that match of their employer. Free money is hard to come by and we want to take all we can get! In our next post in the series, we will provide visual aids to further encourage you to begin your contributions to construct your walls!

Resources:

  1. http://www.investopedia.com/ask/answers/100314/whats-difference-between-401k-and-pension-plan.asp?ad=dirN
  2. https://www.irs.gov/retirement-plans/plan-sponsor/401k-plan-overview
  3. https://www.irs.gov/retirement-plans/plan-participant-employee/401k-resource-guide-plan-participants-general-distribution-rules