I work with and know many young professionals. One of the things I’m certain they hear about often is the importance of 401k’s. Whether or not they have a good understanding of them is a different question. However, there is one thing I’m absolutely certain young professionals do know and understand: Chipotle burritos. I’m about to use the latter to explain the former. I hope you’re impressed.
Tortilla = Account title
I occasionally hear some variation of this phrase said to me: “Yeah, I’ve purchased one of those 401k or IRA things”. That would be an incorrect statement. You do not buy a 401k. You buy things within a 401k. It is only an account tile, a wrapper for your investments, which informs the IRS how they should be treated tax-wise. Just like your giant flour tortilla is not a burrito; it’s a wrapper that makes it clear you’re not having tacos.
What are those tax benefits that the 401k wrapper is indicating? Well, for a traditional 401k, it indicates that all the money contributed to the account is pre-tax and should not be counted as income. It also indicates that any gains generated within the account occur tax free. Taxes are not due until you start withdrawing income from said account. If the withdrawals occur post-age 59.5 then you’ll owe based on your normal income tax rate; if the withdrawals are pre-59.5 then you’ll owe based on your normal income tax rate plus a potential 10% penalty.
If it’s a Roth 401k, take the first half of the last paragraph and just reverse everything. Money contributed to a Roth version is still required to be included in your income. However, withdrawals taken post-59.5 are completely income tax free. Gains generated within the account still occur tax free. Withdrawals pre-59.5 could potentially be taxable and incur a 10% penalty but only on the portion recognized as gains.
Filling = Investments
The things you do actually buy, investments, are the fillings to your 401k tortilla. The investments can include a wide range of options including stocks, bonds, and real estate. Just like with actual burritos, the way these “fillings” are allocated depends very much on the individual person. Someone who dislikes beans (like me- I hate them!) will exclude them from their burrito, just like someone who already owns multiple pieces of real estate might exclude that asset from their 401k allocation.
Match = Double Meat (For Free!)
For some absurd reason, imagine being offered double meat for your burrito just for showing up. Would you turn that down? I’m pretty sure if you did, your friends would call you a dumbass! In a respectful and courteous manner, of course. (Except you vegetarians, I know, I couldn’t come up with anything better. What can I say; I’m a financial planner not a writer!)
That’s the equivalent of not getting your full employer match on your 401k. It’s one of the biggest advantages of having a 401k. Plan documents use language that makes it sound somewhat complex but it’s not. For example, a generous employer might offer a 100% match on the first 5% of income you contribute. That means if you contribute 5% a paycheck your employer is depositing the exact same amount for you into your account. You are instantly doubling your money! There are very, very few reasons to not do this!
That’s it. Those are the 401k basics, explained to you with the help of an extremely popular fast food. I hope this helps you get a better understanding of your 401k. Mostly, however, I just want you to think of me and saving more money every time you enter a Chipotle from now on.