401Ks Explained: The Basics of the Retirement Buzzword

Retirement savings may not be the first thing on your mind when you get your paycheck, but it’s never too early to start planning. Interactive Brokers’ Senior Manager of SEO and Content Cassidy Clement and Total Rewards Manager Barbara Olander discuss 401k retirement savings plans. They cover some of the basics of 401ks and discuss what investors should think about when assessing this type of retirement plan.

Summary – Cents of Security Ep. 4

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Cassidy Clement

Welcome back to IBKR’s Personal Finance podcast. I’m Cassidy Clement, Senior manager of SEO and Content at Interactive Brokers. Today, I’m your host for our 401K podcast and our guest is the Total Rewards manager at Interactive Brokers, Barbara Olander. Welcome to the program everyone. We’re going to cover some of the basics of 401K’s and then we’re going to discuss what investors should think about when assessing this retirement plan for themselves. So welcome, Barbara.

Barbara Olander

Hello everyone.

Cassidy Clement

 So, we’re going to talk a little bit about the 401K’s in retirement today. Let’s just hit off some basics here —so, what is retirement? How do I get there?

Barbara Olander

 Well, I guess depending on where you live in the world, retirement could mean a couple of different things. Focusing on the U.S., retirement typically means when an individual leaves the workforce for good with the intention to no longer be part of the workforce— traditional retirement age is 65. Again, this is in the United States and with the rising life expectancy rates across the globe, retirement period could mean a couple of different things. Now obviously, retirement due to its duration could impact individuals significantly in trying to decide how much money or how well they need to be secured in order to live happily through their retirement life.

Cassidy Clement

How could a person then prepare for this retirement or at the end of their workforce journey?

Barbara Olander

Well, one way that individuals can prepare for retirement is through the use of a retirement account. The idea is to accumulate funds while they are working in order to then use those funds later on in retirement. For some, that may mean a pension— that’s an uncommon option— in the U.S. Individual retirement accounts are a different one, but the most common way for individuals to save for retirement is through the 401K account, which is an employer sponsored account.

Cassidy Clement

Got it. So, I guess we’ll just begin with our conversation here into that which is the 401K. So, you know, what is it? And let’s talk a little bit about how it’s offered to employees and how it interacts with them and their employers. If you want to give us some clarity on that.

Barbara Olander

Sure. So, I guess the basic question would be ‘What is a 401K?’ So, a 401K retirement account is an employer sponsored retirement plan. It is one of the most common ways that employees can save for retirement. For one case, offer employees a tax advantage when they choose to save in a 401K account. Employees can sign up for 401K accounts and agree to have a portion of their pay directly deposited into this retirement account. Their designation could either be a percentage of their pay or a hard dollar amount— that’s obviously dependent on the specific plan setups and requirements. In some instances, the employer will match the employee’s contribution, meaning that whatever amount the employee chooses to contribute, the employer may, in full or in part, also contribute on their behalf. And then lastly, the employee gets to decide based on sort of a pre-selected fund option where they wish to deposit that money and where they wish to invest that money.

Cassidy Clement

So, it sounds like, with some of this, that there’s different ways for it to be advantageous for different people, especially utilizing the different pieces that are coming from an employee to employer match and then also the various funds for investing. Let’s talk about some of those types of 401K’s— most people are familiar with, you know, the basic, which is your standard issue pretax 401K. And then also we have the Roth; if you want to just give some examples and some ideas for that, I think that’d be helpful for our listeners.

Barbara Olander

Sure. Absolutely. So just to help level set here, right, so the traditional 401K account is the pretax 401K account. Employees contribute, like they said, on a pretax basis and their contributions reduce their taxable income. The money that they invest grows on a tax deferred basis, which means that the employee pays taxes on the amount that they have contributed only upon withdrawal of those funds. On the other hand, the Roth 401K account allows individuals to contribute money on an after-tax basis; there’s not a tax deduction in the contribution year, but there is a tax advantage when withdrawals are made.

Cassidy Clement

Got it. So, then as some employees start to look at this or people entering the workforce, I’m sure their first question would be— How do I start contributing? Is this automatic? Do I just show up as a new employee and it’s like ‘poof, your 401K’s here?’ Maybe there’s a few different ways, I’m sure, so tell me a little bit about that.

Barbara Olander

So, as mentioned, 401K plans are employer sponsored plans. Employers frequently want to encourage their employee base to contribute to the retirement plan. Most frequently, the employee receives information about how to enroll, when to enroll, any applicable contribution limits, and the frequency of being able to make changes to their contributions. But all of this information is and should be shared with the employee when they join their employer. It frequently becomes a part of the benefits package and the overall offering that the employer is able to provide.

Cassidy Clement

Is there anything like an automatic enrollment that’s coming up? I know a lot of people have been talking about that, and for the people who are nearing retirement and the people just getting into the workforce, I’m sure that’s kind of a hot topic right now. If you want to hit on that.

Barbara Olander

Currently, some employers offer an auto enrollment into the 401K plan. That feature is very much planned, specific, and employer specific. It may not be an automatic setup depending how the plan is designed; however, beginning in the near future, in just a short couple of years, as part of the Secure Act 2.0, new plans will be required to have an auto enrollment feature. If you’re looking to change your employment in the coming years, that may be more of a norm as opposed to the exception to the rule. Let’s say you were to go venture out on your own and become self-employed or run a small business, you may be eligible to set up and start a solo 401K plan or an independent 401K plan. Those obviously have specific rules and criteria that need to be met.

Cassidy Clement

Right. So, there’s definitely flexibility here and it seems like as you enter the workforce or as you start to get exposed to 401K’s, you’ll see so many different types and ways to contribute. But I guess the one thing that people initially hear after they read about the benefits is— ‘that’s great but how do I decide how much to contribute?’ I’m just starting out, let’s say, or i’m trying to save for, I don’t know, a car or a house or something like that—what’s the way to kind of derive, if possible, a good contribution formula?

Barbara Olander

So yes, very valid and typical concerns, especially for those just starting out in their careers trying to figure out how much they can devote towards their lifestyle versus their savings goals and then finally focusing on the retirement aspect of their careers. There is not a single solution that fits all. However, the prevailing suggestion and advice is that contributing 10% of an employee’s gross salary towards their retirement income is ideal, or at least is a starting point. Now, if it is not possible due to, you know, like I said, a new grad joining the workforce, maybe they have other savings goals that they want to address, first but contributing even one or two percent is obviously better than zero.

Cassidy Clement

So, it seems like if you have the opportunity, you definitely assess it because you want to give something because it’s better to give something than nothing.

Barbara Olander

Exactly. The next thing I would say is that if the employer offers a matching contribution, the next thing to consider as far as selecting a contribution percentage would be to try to contribute as much as possible in order to receive all of the employer match. That obviously would mean that the employee benefits as much as possible from what the employer is offering them for retirement savings.

Cassidy Clement

Right. It’s kind of the leaving the money on the table scenario where you want to make sure if you’re able to do it and maybe take a look at it and consider it. Because you don’t want to just leave the money there if you know it’s potential for you in the end. So then with that, I guess are there contribution limits for what you can and can’t do because it sounds great, but I’m sure people are like— ’eh it might be too good to be true, tell me some more.’

Barbara Olander

The IRS decides on the annual contribution limits for 401K plans. In 2023, the pretax and Roth employee contribution limits are 22,500. Now, that is the amount that an individual can contribute to their 401K plans whether it be a single one in the year or if they have multiple employers in a given year. It is the combined total of the amounts that they are able to contribute and then for individuals who are 50 years old or older, there’s an additional amount— $7500 in this calendar year, 2023. That’s called a catch-up contribution. That’s obviously intended to allow employees who are closer to their retirement age to set aside additional funds for their retirement.

Cassidy Clement

Got it. So, when we’re looking at these different types of plans and then, I guess because they’re investment items and portfolios or products, are there fees associated with 401K retirement savings plans?

Barbara Olander

Yes. So, depending on the plan set up, there could be management fees or expense ratios that all 401K participants should review and consider. With administrative fees, because they are plan level fees, the individual may have no control over how much they pay. However, some employers cover those fees, some of them have a sharing arrangement, meaning the employee and the employer sort of share the cost of the administration. And then lastly, in some instances, the employee is solely responsible for those fees.

Cassidy Clement

I guess the next course of action would be somebody to say, ‘OK, great. I did all this. I reviewed all of the different funds and fees and what plan I would like, but how do I take the money out now that it’s there?’ Let’s move up a little bit from the starting line to the finish line. How do you take the money out?

Barbara Olander

Right. So obviously the retirement plan account is intended to be a vehicle through which an employee saves money for retirement. And the employee should use that account less so as a savings account from which they can periodically withdraw money, but more as a sort of set it and forget it type of savings place, and only really focus on using that money when they are in their retirement years. However, life happens, different situations come up and sometimes it is impossible for an employee to not access their funds. There are limited ways through which funds can be accessed from the 401K account. One of those ways is through a 401K loan. A loan lets the employee borrow money from their retirement savings account, and then the employee pays it back to themselves with interest over a period of time.

Cassidy Clement

Are there any taxes or penalties with that?

Barbara Olander

No, there are no taxes or penalties when taking out a loan, assuming that the loan is paid back in full. And then the interest you pay on the loan gets back into your retirement account as well. So, it is one option.

Cassidy Clement

Got it. So, then I’m guessing the withdrawal option then is going to be more permanent because it’s removing it directly.

Barbara Olander

Right. So, if an employee is in a desperate need and the loan option is not available to them, a withdrawal of funds may be possible depending on their circumstances. Obviously, the withdrawal permanently removes the money from the retirement account. And may carry fees and taxes associated with removing the money. I should probably point out that a hardship withdrawal applies only when an immediate and heavy financial need exists to the employee, such as of severe medical expenses or if the employee faces foreclosure or maybe has tuition payments that they are required to pay. There are very specific instances which allow an employee to withdraw money from their account before they are in that retirement age.

Cassidy Clement

So, then I guess for that last piece you mentioned when we’re talking about rollovers, I’m sure some people think, you know, I’ve started at a job, I’m feeling it out, I want to do the right thing and contribute. But, you know, what happens if down the line I want to jump to something new. How does that rollover work?

Barbara Olander

So, assuming that both of the current and the new employer offer a 401K plan, it may be possible for the employee to roll over—essentially transfer the money from one plan to the other. That way they are able to keep their money invested in the available funds and would not face any penalties just by moving the money from one account to the other. Definitely something to consider, especially, you know, later on in your careers as you may have had two or three different employers, it is probably better to have your money all in one account as opposed to spread out over different old employer accounts, which may be difficult to track.

Cassidy Clement

At different times, you had different goals for your money. So, you may have things with different ideas in mind of how they were invested. So, it seems like there’s some flexibility in the way that these are structured. However, you know, there’s clearly some rules here because it’s focused on a retirement end game, not necessarily just growing some money for a later date. But when there are a lot of people entering, you know, the workforce, as we’re reporting this in May, as people start to graduate college and they start to take on some of their first jobs, they might just be thinking ‘, hey, listen, this seems a little premature. I just got my first job. Why is it so advantageous to start right now? I just got my diploma. I just flipped the tassel.’ So, you know, could you give a little bit of insight on how investing earlier is going to help with some higher potential later?

Barbara Olander

Sure. Well, investing early allows you the opportunity to have that money work for you and grow over a long period of time. That, I think, is the most important lesson to take away from the information we are sharing today that, you know, like I said earlier, maybe you are not able to contribute at the levels that you want to right from day one. But even that one or two percent can grow over a long period of time to be a significant amount.

Cassidy Clement

So, what should employees ask their employees about the plan if they have anything?

Barbara Olander

Well, I think it’s important for every employee to understand their employers’ offerings. Understanding the basics of ‘how do I enroll?’ ‘How much am I able to contribute?’ How often can I make contribution changes?’ But also, obviously understanding who is managing the plan. Is there a contribution match? Are there any other plan specific rules and criteria that the employee needs to be mindful of or abide by in order to take full advantage of the offering?

Cassidy Clement

Right. And then I’m guessing that with those questions that will give light to why people should make the most out of that employee contribution. So, I guess finally the last piece would be, you know, when people are looking at different fund options, is there a certain idea of what they should be looking for? I know retirement age; volatility might have something in there.

Barbara Olander

So yes, the selection of funds is probably the more difficult question when it comes to 401K’s. Obviously, as an employee and as a planned participant, you want to review all of the funds that may be available to you without digging into the different funds that are available to you and matching the funds as closely to your specific fund preferences. A target date fund may be a good option. A target date fund allows you to invest your money— it is managed through the plan and through the funds that obviously the plan participates in, but a target date fund takes under account how much time the employee has between the date that they start investing and the sort of end date or the projected date of their retirement. The fund that obviously begins earlier on is considered to be more aggressive in the specific funds that maybe a part of it and then becomes less and less aggressive as time goes on and as we get closer to that retirement age.

Cassidy Clement

Thanks for all that information. I think these are great questions that we answered that people may take into account when looking at starting a 401K journey or contributions. But I want to thank you for joining us, Barbara. And listeners can learn more about an array of financial topics for free at IBKRcampus.com at any time. To the audience, thanks for listening.