The Economic Blueprint: How a 401(k) operates

It’s test day. You have your stack of black or blue pens, your scratch paper and your bottle of water.

The instructor passes out the bluebooks and the three prompts that will somehow test everything you’ve learned about constitutional law over the last four months.

She instructs you to begin and everyone around you starts scribbling furiously. There’s just one problem: you forgot to study!

Thankfully, you wake up and remember that you graduated from law school ten years ago. There will be no constitutional law final exam today, or ever again.

As lawyers, many of us are “factfinders” who prefer to have all the information before moving forward.

When it comes to counseling your client on saving money, or even saving your own money, it’s important to know how these financial tools operate.
401(k) study materials

In my last column, I asked whether maxing out a 401(k) is an optimal strategy. To answer that question, the proof will be in the pudding. For now, let’s review what a 401(k) is and how it functions.

A 401(k) is essentially a basket of mutual funds intended to help people save for retirement. Individuals are not taxed on the dollars they contribute, and then that money grows tax-deferred. The money is taxed, however, when they withdraw it in retirement.

In addition to employee contributions, employers may offer a match. Each employer has different match terms, which may be described as “50 cents on the dollar up to 4 %.” That would mean for every dollar the employee contributes, up to 4% of her income, the employer will contribute 50 cents into the account.

In 2019, the contribution limits are $19,000 per person per year. For those age 50 and older, they may “catch up” and contribute an additional $6,000 per year.

The contributions then accumulate and grow in the account without being taxed, and at age 59½ the employee may begin withdrawing from the account.

Earlier withdrawals are subject to taxes and penalties, except for a few narrow exceptions. Then at age 70½ employees are required to withdraw the Required Minimum Distributions (RMDs).

Advantages and disadvantages of a 401(k)

There are certainly benefits to contributing to a 401(k). It creates an automatic savings plan because money is directly contributed out of the paycheck.

The savings then accumulate and grow tax-deferred, meaning there are no taxes as the account grows, unlike with an individual brokerage account.

At the same time, there are disadvantages to over-contributing.

First, the money will be taxed upon withdrawal in retirement, but at what rate? Many experts opine that federal income tax rates will increase substantially in the coming decades.

Some believe rates will go back to 50%, like they were in the 1980s, or even higher. If that happened, a retiree might have to withdraw $200,000 per year just to spend $100,000.

Second, although the money belongs to the employee (sometimes with a vesting schedule), she can’t touch it until age 59½ with some narrow exceptions, such as a first-time home purchase, education expenses, or hardship. This nearly complete illiquidity prevents her from leveraging her wealth by keeping it flowing among assets.

Third, there is minimal risk protection. Namely, stock market risk: ask anyone who wanted to retire on their 401(k) in 2009.

There are also human risks such as being unable to work because of injury, illness, or death. If someone stops systematically contributing then the account won’t serve its purpose. A 401(k) is not a comprehensive strategy that considers protection against downside.

Fourth, there is limited contribution flexibility because of the annual limits. Imagine someone who experienced financial hardship for a few years and was unable to contribute.

HowLet’s say she started a business, which became very successful several years later. The contribution limits would prevent her from making up the difference in the lost years of contributing once her business becomes successful.

Test day

Law school exams don’t require students to memorize and recite facts. Instead, students must know the case law to analyze potential outcomes of new fact patterns.

With this basic information of how a 401(k) operates, my next column will provide some rules of thumb about how we can apply the rules and utilize a 401(k) for optimal results.
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Attorney Kyle Zwiren works with Financial Architects Inc., an independently-owned company located in Farmington Hills. Kyle and his team serve attorneys and other professionals to help them design financial plans in line with their goals and based on optimal efficiency. Kyle practiced law prior to becoming a Financial Architect and left the practice to follow his passion. To talk to Zwiren about other topics featured in The Economic Blueprint, email him at kzwiren@financialarch.com or call him at 248-482-3622.