Retirement Series: 401k
Table of Contents
Introduction
This article is geared towards new graduates who are high earners in the tech industry. During your onboarding, you will have to elect your employer-provided retirement options, namely 401k options. Since this is your first full-time job, you may have moved across the country, it can be hard to focus on making sound retirement choices, especially since optimizing them is quite complex. You will likely be presented with the options to
- Select your employee contribution
- Select Roth vs Traditional
- Consider After-Tax (Mega backdoor) contributions
- Consider employee matching plans
- Select a fund
Luckily, we can walk through and make practical choices for all these options.
Summary: Practical Advice on How to Handle 401k
In summary, as a high earner in the tech industry, you should
- Max out your 401k contributions to meet the federal limit and elect all contributions to be traditional [1]
- Max out the after-tax contribution (if provided by employer)
- Select the retirement fund for when you turn 65
You want to make all your 401k contributions in the traditional bucket because all the after-tax contributions will eventually end up as Roth. The end goal is to have balanced Roth and Traditional buckets across your entire retirement portfolio (including your IRA).
After-tax contributions is a legal way to contribute more than the federal limit on 401k. More details later.
You want to select a fund far in the future so it can be more aggressive. Further, these funds are likely to have a low expense ratio.
401k Overview
A 401k will likely be offered by your employer to help you save for your retirement. The federal contribution limit changes year-to-year, but will be around 22k. There is a means to contribute a total of around 60k to your 401k via a Mega backdoor, which we will discuss later.
Matching Contributions
One important incentive of the 401k is employers often match employee contributions (typically, they contribute dollar-for-dollar up to 3-6% of pay). Employer matching should be considered part of your salary and MUST be leveraged. The matching funds contributed by an employer are always in a traditional bucket (as opposed to roth). These funds are only taxed when they are withdrawn.
Withdrawing
The Internal Revenue Service (IRS) has established guidelines permitting penalty-free withdrawals from retirement accounts post the age of 59 ½, while mandating withdrawals commence no later than age 72 [2].
In certain situations of financial hardship, such as specific medical expenses, individuals are allowed to withdraw from their 401k without incurring the typical 10% penalty. All appropriate taxes must still be paid (double whammy) [3]. However, these qualifying rules for hardship withdrawals are stringently applied and usually exclude scenarios like purchasing a home for the first time.
First-time homebuyers are permitted to take a loan from their 401k, with the stipulation that this loan, plus interest, is repaid within five years. The interest paid on such loans is effectively paid back to oneself, and there's a cap on the borrowing amount, which is less than $50,000.
Ideally, you never have to rely on early withdrawal OR taking a loan against your 401k. Early withdrawals eliminate the tenants of 401k advantages: tax savings, compounding interest over a meaningful time period [4]. When thinking of taking a loan, refer to a bank or other strategies.
Roth and Traditional 401k
When electing 401k contributions, you will have to decide whether you want to contribute to a Roth or Traditional 401k account:
- Roth: taxes are paid on contributions but no taxes are paid on withdrawal.
- Traditional: no taxes are paid on contributions; they are made directly from your paycheck and reduces taxable income for the year. Taxes are paid when funds are withdrawn and are paid at the tax bracket during withdrawal.
The biggest advantage of Roth is that earnings are not taxed. This is very significant as earnings will be compounded over many decades leading to retirement. Traditional is advantages because your tax bracket will likely be much lower during retirement (as your spending on mortgages, taxes, college fund, etc. decreases).
Should You Prefer Roth or Traditional?
This question is not possible to answer optimally without knowing your future financial situations. Typically you want to invest in both types of accounts via a 50-50 split; at retirement, you can withdraw from traditional accounts up till the upper bound of a tax bracket, then supplement the rest of your income with Roth withdraws
To achieve a 50-50 split, you DO NOT want to split your contributions 50% Roth and 50% Traditional. This does not consider your entire retirement portfolio, which will likely consist of after-tax Mega backdoor contributions, backdoor IRA contributions, and employer contributions. Mega backdoor contributions and backdoor IRA contributions are mandatory Roth contributions; these contributions will make up a bulk of your retirement. Thus, all your 401k contributions should be 100% Traditional to achieve a 50-50 split between Roth and Traditional across your entire retirement portfolio.
Mega Backdoor Roth 401k
Not all companies offer Mega Backdoor 401k contribution options. However, all the FAANG/MANGA companies do offer it. The Mega Backdoor Roth enables substantial additional contributions to a Roth account—around $40,000.
To begin a Mega Backdoor, you must also elect to contribute to the 401k After-Tax bucket. You can then use your retirement account to automatically convert these funds to a Roth bucket. Almost certainly, other employees at your company will have started a discussion thread on this topic and streamlined the process for you. You can look up the process via Slack or other means.
Note that After-Tax contributions are made with post-tax dollars. However, upon withdrawal, After-Tax contributions are taxed again on earnings (double taxed compared to Roth). This is why converting the After-Tax bucket to Roth is paramount.
Roth contributions have an annual limit of approximately around $20k while After-Tax contributions are bounded by the overall 401k limit of about $60k. If you contributed 20k to Roth and Traditional buckets, then you can contribute 40k to the after-tax bucket ($60k - $20k = $40k).
Following a Mega Backdoor Roth contribution, you will receive a 1099-R form from your retirement account. This will be necessary to file out a Form 8686 to detail the conversions that happen. If you use a tax software, simply follow the instructions with your 1099-R in hand--the process is simple.
FAQs
Please feel free to submit your questions here. I will answer the most popular ones!
Read Next
- Retirement Series: IRA
- Retirement Series: Taxes
References
[1] IRS 401k limit here
[2] IRS 401k distribution criteria here
[3] Early withdrawal penalties and taxes here
[4] Retirement FAQs: why contribute to retirement here
[.] More sources incoming…