Tax deferred retirement accounts are an important tool for gaining financial freedom and retiring early. This post explains what a 401(k) plan is and the five key benefits they offer to help you save for retirement as well as helping you to invest in rental properties.
A 401(k) plan is one of the most common tax deferred retirement accounts. The name 401(k) corresponds to the respective Internal Revenue Code for this type of account. A 401(k) plan is for those who work in the private sector, a 457(b) is a similar account for those who work in state and local government and a 403(b) is an account for those who work in the non-profit sector. The federal government calls their plan the Thrift Savings Plan. These plans all operate in a similar manner, although there can be differences in the investment options available to account holders. For the sake of ease, all of these accounts are referred to hereafter as a 401(k) plan.
The maximum employee contribution for a 401(k) plan for 2020 is $19,500. Expect the maximum amount to rise by $500 every year or two to help savers keep up with inflation. There is also a catch-up period for workers aged 50 or older allowing them to boost their contributions by an additional $6,500 per year. A 401(k) plan will usually offer options of broad stock index funds, bond index funds, U.S. Treasuries, and possibly company stock. Your employer can explain the investment options available in your plan. Personally, our 401(k) plans are mostly invested in an index fund that matches the S&P500 index, as well as smaller holdings in an index fund of small capitalization stocks that matches the Wilshire 5000 and a similar sized portfolio invested in an index fund of corporate bonds.
A 401(k) plan offers four important benefits to help you achieve financial independence. These include:
1. Reducing Current Taxes: Contributions to a 401(k) pare are made pre-tax, which means they the funds are taken out of your salary before you pay federal income tax, state income tax or FICA tax (7.65%) on the money. By contributing to a 401(k) you are taking the dollars that would be taxed at your highest marginal tax rate and not paying taxes on them now. For example, Enoch is single and earns a salary of $59,500. He chooses to maximize his 401(k) contribution at $19,500 so he will only be taxed on a salary of $40,000 ($59,500 - $19,500 = $40,000). If his $19,500 in salary falls in the 22% tax bracket he would save $4,290 in federal income tax, plus FICA tax of 7.65% and any state income tax that would have been applied. This is a significant reduction in your tax bill for the current year. The government is essentially rewarding Enoch for choosing to save this money and it will dramatically add to his net worth if he does it each year.
2. Employer Match: Most 401(k) plans provide an employer match up on some or all of your contributions. For example, if you contribute 5% of your pre-tax income to your 401(k) plan, your employer may match that 5%. If you contribute $5,000 and your employer matches it with $5,000 you have already doubled your money! That is no risk 100% return on your money. There are very few opportunities to double your money with zero risk. The employer match allows you to accelerate your savings rate up by adding to the amount you saved. Some employers are more generous than others so check what your employer offers as a match for your 401(k) plan.
Employees who contribute the $19,500 maximum limit for 2020 can receive up to $37,500 in an employer match and profit-sharing contributions. Thus, the total contribution amount for the year would be $57,000 (split between $19,500 from the employee and $37,500 from the employer). Make it a priority to at least contribute to the level of your employer’s match to benefit from this free money.
3. Proof of Reserves: We talk a lot about real estate investing in the book Become Loaded for Life and your 401(k) account can be a valuable tool in helping you buy real estate. When qualifying for mortgages, the bank will want to see that you adequate financial reserves. Reserves are other assets that you owns that could be liquidated to help pay back the loan. A 401(k) account can serve as those reserves. Our 401(k) accounts helped us repeatedly when applying for loans, particularly after the global financial crisis when lenders became skittish about lending on real state. Being able to buy when others cannot, and prices are low, is tremendous way to create wealth.
4. 401(k) Loans: Many 401(k) plans allow employees to take a loan against their 401(k) balance, which is then be paid back over a few years through payroll deductions. You don't have to pay any income taxes on the loan or the 10% early withdrawal penalty as long as you pay the loan back properly. If you fail to pay back the loan, the outstanding balance will be treated as an early withdrawal and is subject to all taxes and a 10% penalty, assuming the employee is younger than 59½ years old. Personally, we have used these 401(k) loans multiple times as the down payment for real estate purchases. We usually take a loan of $24,000 each for the down payment and pay it back over a two or three-year period using the rental income.
5. Power of Compounding Interest: By maximizing your 401(k) contributions earlier in your career, you will benefit from the power of compounding interest over several decades. For example, if Nyla begins her career at the age of 25 and contributes $14,000 and benefits from a $5,000 employer match she will be saving the current maximum contribution of $19,000. After ten years her account would have $190,000 for retirement. But, if Nyla’s had invested her contributions in a mix of stocks and bonds that grew at an annual rate of 7% for these ten years her account would have approximately $275,000.
The power of compounding interest is most effective when it has time to grow. For example, we saw that Nyla’s ten years strategy earned her approximately $2750500 by the time she was 35. If Nyla never contributed another dollar but maintained a 7% average annual return for the next 24 years, her account would have approximately $1,470,000 at the age of 59. Nyla has become a millionaire from this one decision of saving for ten years and then not touching the money for the next 24 years.
There will be volatility in the stock market from year to year, but historically money left to grow in a fund that tracks the S&P 500 index will earn a 10% average annual return (1928 to 2014). Nyla only used a return of 7% per year, which factors in the potential for some significant downside risk in her future returns. If her investments perform better with an 8.5% average return for the 24 years that she kept her contributions in the market she would have approximately $2.1 million when she is 59 years old. She would be a multimillionaire from saving for only ten years. If you wish to experiment in calculating returns on different investment amounts and rates of return retirement please see the investment calculator at SmartAssets.com.
Options to Access 401(k) Funds for Individuals Seeking to Retire Early
One key drawback for 401(k) plans is that those who intend on retiring early in their 40s or early 50s, will not be able to begin withdrawals until the age of 59½. However, the good news is there are several options to access these funds at age 55 or possibly earlier. See the post on this website Access Your 401(k) Money Before Age 59.5.