A 20-Something's Guide To Understanding The 401(k)

In 1980, Ted Benna, a benefits consultant, interpreted Section 401(k) of the Internal Revenue Code as a provision for highly compensated employees — read: executives and upper management — to electively defer their compensation to a later time to presumably be in a lower tax bracket.

Ever since then, employers have pounced on the opportunity to shift the investment risk from their corporate balance sheets onto those of their employees. Trying to find a non-union, private employer that still offers a worthwhile pension plan is like trying to find a CVS with Plan B in stock after homecoming weekend.

Your HR department might esoterically refer to the 401(k) as a defined-contribution, employer-sponsored, tax-qualified, profit sharing plan. While it might sound as complicated as having sex with your girlfriend when you're staying at her parents' house over Thanksgiving weekend, in both situations, all you need is a bit of patience.

To break that down:

Defined-contribution.

You, the employee, specify an amount of salary you’d rather send to the financial equivalent of a 40-plus-year stay at Guantanamo Bay as opposed to having it readily available to make it rain at your local strip club.

Employer-sponsored.

More often than not, they really mean, “outsourced to a third-party administrator (or TPA.)”  The greater majority of TPA's will provide you with a limited selection of over-priced investment vehicles. Think of the beer selection at a Pittsburgh Penguins game... You can either have IC Light or Labatt Blue. If you went somewhere else, you'd have a much greater selection from which to choose.

Tax-qualified plan.

Here, qualified refers to tax-qualified treatment from the IRS.  Rather than taxing you on your compensation, the IRS would prefer you to invest those earnings so that they can piggyback on your investment growth without the risk and hopefully take even more, come distribution time.

Profit-sharing plan.

If your employer decides to do this (and this decision is completely discretionary, mind you) they will either contribute a specified percentage of your salary — regardless of whether you elect to make a contribution — or match a specified percentage of your contribution. However, this is only if you contribute.

“But everyone says 401(k)'s are for retirement...”

Wake up. What has become synonymous with a retirement plan was never meant to have anything to do with most individuals... or their retirements. Again, it was created as a tax-dodge scheme for high-income earners.

That bears repeating: The advent of the 401(k) was never meant to be the foundation of a retirement plan, but unfortunately, a lot of people just don't know any other way.  The fact that Section 401(k) of the IRC has evolved into what it is today might make you think that there aren't any alternatives. Think again.

If employees truly understood their qualified savings plans, they would most likely not be flocking to participate. And to ensure that the flocking does occur, most 401(k) plans instituted automatic enrollment for their employees, which means you now have to proactively opt-out of participating. Why do your employers care whether or not you participate?  Short answer: they need you to do so.

If employers don't have enough “common law employees” participating, they may be in violation of what are called "safe harbor" rules. The employer would then be required to contribute 3 percent of compensation for all participants, regardless of an employee's individual contribution. Needless to say, you can be sure that employers are keeping a close eye on this.

The chances of an employer inadvertently violating safe harbor rules are about the same as an engineering major’s chance to hook up with the football team’s head cheerleader.

“Should I still participate? There has to be a benefit... right?”

Truth be told, most 20-somethings shouldn’t participate. Aside from the employer match and the forced savings component, there really isn't much of a benefit for doing it. Yeah, you're saving money, but the benefits certainly don't outweigh the consequences.

Do yourself a favor: make a budget. When the next real investment opportunity comes along, you'll thank yourself that you have the seed capital readily available to contribute to the business venture. This is called liquidity.

Illiquidity is a characteristic of the 401(k). As the Internal Revenue Code currently stands, you aren’t able to get your contributions out until you are nearly 60 years old.2. If you take no withdrawals from your account, the gross amount will be subject to a 10 percent penalty and will also be taxed as ordinary income. While you are able to take a loan against your 401(k), there is Inflexibility as to the amount, the reason and the term.

“For the lemmings, who are still hell-bent on being able to tout percentage contributions to their 401(k) over lunch at Ruth’s Chris, when should you start?”

You shouldn’t even think about contributing, to anything for that matter, until you have at least six months of liquid savings. Liquid, meaning if you had to come up with the cash quickly, you could and you wouldn't be taking a haircut. Then, if you're still interested in contributing, consider electing to defer just up to the employer match... if there even is one.

“Still though, I know finance bros who work at PwC and say I'll pay less in taxes if I contribute to my 401(k)...”

They are correct — you will pay less in taxes because your adjusted gross income will be lower. Your checking and savings accounts will also be lower. But did Kevin ever mention what your taxes will look like come retirement time? Or did he just spew the "you'll be in a lower tax bracket" line?

Unless you're interested in a tax explosion at retirement, you might want to consider an alternative.

“What are the alternatives?”

Like trying to get from sober to drunk at the bar when it's already 1 am, you'll find that you would have been a lot better off had you just planned ahead and pregamed.

There are two alternatives that will leave you thanking your 20-something self for having a bit of foresight when your fecal incontinence kicks in around your mid-70s. 1. A Roth IRA and 2. whole-life insurance.

Remember, the adage of six to twelve months of liquid savings still applies.

What makes these two alternatives shine brighter than your future without the 401(k) is that they act as a hedge against an increase in taxes. You very well may be in a lower tax bracket at retirement, however, that doesn't mean you'll necessarily have a lower marginal or effective tax rate.

Even better though, distributions are received tax-free (including distributions for the whole-life insurance). With the Roth IRA, after five years, in the event of an emergency, you'll be able to withdraw your contributions penalty-free, as well.

And for those individuals who are smart enough and successful enough to invest in whole-life, withdrawals are not included as income for tax purposes. In other words, Social Security benefits aside, if you hypothetically had all of your retirement income coming from the cash value of your whole-life policy, you might even receive a tax credit.

The sharper tools in the shed might be questioning why I didn't bring up the Roth 401(k). The only reason someone should opt for the Roth 401(k) over the Roth IRA is if he or she is uninsurable or highly rated.

If you learn nothing else from this, hopefully you'll take an interest in finding out how some of the things really work in your life, financially speaking. And if you don't want to do this, find an advisor who will.

Photo credit: Shutterstock