Essential InSights

Core Topics for the Everyday Investor

Account Types: 401(k)

Account Types: 401(k)

The ‘Standard’ Employee Retirement Plan

Annual Contribution Max: $19,500 or $26,000 if over 50 years old. 

Why we like 401(k) plans:

  • An easy option if you’re an employee
  • Automatic Enrollment
  • Can have Employer matching contributions
  • High contribution limits for employees when compared to a Traditional IRA, Simple IRA or Roth IRA
  • Can be added with other retirement plans like a profit sharing plan enabling for greater contributions
  • Tax-deferred growth 
  • Reduce income tax liability with each dollar contributed
  • Systematic savings
  • Access to loans 
  • Creditor protection when 401(k) qualifies under ERISA
  • It speaks a Common Language, it’s familiar
  • Portability after employment (

Why we don’t like 401(k):

  • Can have limited investment options
  • It may take several years before you fully own your employer’s matching contributions (dependent on vesting schedule with employer)
  • Requires a Fiduciary Standard of Care for the oversight 
  • Can be expensive to set-up, administer, and maintain

You’re likely familiar with this plan and it could be a very convenient retirement plan option for many companies. Companies usually strive to make it easy for employees to set up and for them to manage on their own. Because a 401(k) is a retirement plan offered by most for-profit companies as an employee benefit you will find most people are familiar with the idea and have in the past contributed by diverting part of their paycheck into the retirement plan.

A 401(k) provides the typical tax advantages by reducing your income and deferring the tax liability into your retirement years. For example, if you earn $78,000 in one year and contribute $10,000 to your 401(k), you avoid paying income tax on the portion you contributed. Leaving your taxable income at $68,000 for that year. 

Tax-free growth is the best part of any retirement plan. The money apportioned in your 401(k) grows tax-deferred until you take it out, at which time you’ll pay income tax on the money you take out. As with most other types of retirement plans and accounted for in the InSight-full® financial planning process, you have to be 59½ or older to withdraw money without penalty, and you’re required to start withdrawing money at age 72. 

Another great benefit of a 401(k) plan is that employers that provide them can also make matching contributions when you put money into your plan. You read that right – it’s free money, growing tax free, for many years potentially. Two points of caution: 1) actually this is money you earned, treat it as such and 2) you may only earn the employer-contributed portion over several years of employment in a process called “vesting”. You should consult your plan document for more details. 

Moderate to High contribution limits. An additional attraction, and part of your strategy should be that 401(k) plans often have high contribution limits and no income restrictions (unlike Traditional IRAs and Roth IRAs): you can contribute up to $19,500 in 2020, or $26,000 if you’re 50 or older. An often unknown fact is that the total contribution limit, including both employer and employee contributions, is $57,000 (or $62,000 for over-50s). 

Limited investment choices and high fees. The most clear disadvantage of 401(k) plans for employees is that you usually have a limited number of investment choices within the plan, such as mutual funds or index funds. And that these may carry a fee that comes out of the total return of the investments. 

essential insights

Other Related Topics:

Definitions: Fixed Income

Fixed Income (or debt) represents your ownership over the repayment of a debt. Usually considered bonds, they are contracts promising the repayment of loaned money. Other forms of debt arrangements include Mortgage-Backed Securities, liens, loans, and CDs. Fixed income is called that because the return is decided on the outset – so the return is fixed from the initial offering. Because the upside is fixed from the start, the change in their pricing is less dramatic. Thus, fixed income pricing becomes less about the asset itself, and more about the prevailing rates for other options (read “current interest rate environment”). Debt is usually priced based on three variables, 1) How likely you are going to get your debt repaid, who owes the borrowed money, and what is the way they will pay it back? (Taxation, revenue, etc.) 2) how long until you are repaid your initial investment, this is called duration and indicates how long the money is at risk for. 3) the rate that the debtor is paying on the borrowed sum, usually expressed percentage as a coupon or yield. There are subcategories based on who the entity requesting the money fall into: Muni’s  – a Districts or Municipalities Debt. Usually issued to fund special projects, schools, or city and municipal improvements. In addition to the yield, these are priced for risk based on cities’ credit history, the source they plan to repay the loan (taxation or toll-based), and any available insurance they put on the bonds. Treasuries – the sovereign debt of a country. This is debt usually supported by the taxing authority of a country and its ability to create (fiat) the money they need. This is priced based on the credit rating of the country, the outlook of its currency, and the yield. Corporate – debt issued by companies and priced based on their creditworthiness. These are divided into investment grade and non-investment grade (called affectionately “high yield”) and then subdivided further. Certified Deposits (CD’s) – debt issued by banks. These are usually issued in small increments and for a short duration. The returns are insured by the FDIC (federal government) Mortgages (MBS) – These are backed by the creditworthiness of the borrower, and usually the risk is mitigated by grouping a pool of mortgages into tranches based on their collective credit rating. Collateralized Debt Obligations (CLOs) – Similar to the mortgages, this is a collection of debts that secure equipment or are backed by specialty financial arrangements.  Often backed by the repossession of accounts receivable or equipment.  

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Definitions: Equity

The term Equity represents any ownership rights over an asset’s cash flow generation potential. As an asset class, there is no guarantee of a return on your investment, it is the most speculative of assets classes and is the only asset class that can have its intrinsic value brought to zero. But because it is ownership without end, and a right to the value in perpetuity, it is also the source of the greatest returns. The math looks like this: The most common sources of Equity are stocks, your home, and other real estate assets. But equities can also include ownership in a business through your own formation, or as the result of a private placement and they also include art, royalty agreements, or leasing agreements.  Other terms for Equity are shareholder value, book value, or stake.

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Definitions: Asset Allocation

Asset Allocation is how we discuss the percent of assets in one of the four main asset classes. It is the balance of risk and reward and is the most reliable leading indicator of the intermediate and long term trajectory of a portfolio. The Asset Allocation is the first place we can adjust to a client individual’s goals, risk tolerance, and investment horizon. Asset allocation is often displayed as a pie chart and discussed in terms of the ratio. For example, the “60/40” is a shorthand reference to a portfolio that is 60% allocated to equities, and 40% to debt. These are used by many firms to place clients into a suitable collection of investments. The four assets classes we define in Asset Allocation are Equity, Fixed Income, Cash, and Precious metals.

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