I have a big problem when it comes to reading investment books. More often than not, the books are written by authors from the USA and many of them include the option of using the 401(k) as a tool to improve their finances, as like what a typical Singaporean would do with her CPF system. It is such a pain because I don’t know what are the actual benefits of the 401(k) and the limitations of it. I also can’t relate to the tips that the books are trying to convey no matter how many times I read it, and because of this, the usefulness of the books isn’t 100% brought out.
Thus, the birth of this post. I’m done with this. And since Miss Niao has quite a few readers from the US, I hope that this post would benefit them as well. I will also be doing a comparison to our own CPF system and would finally be able to understand how the two match up in terms of sustaining our retirement needs.
So what the heck is a 401(k)?
In layman terms, it is just another retirement plan being offered to employees. If you are an employee, I highly recommended that you check out if your company has a 401(k) plan available, sometimes even before you join the company. The plans differ for each company and thus the matching contributions would also vary.
So say, for example, your company offers you a 401(k) plan as with the following matching contribution of dollar-to-dollar for up to 10% of your annual income. If you have an annual income of $100,000, you can choose to take a maximum of $10,000 to place it into your 401(k) plan, and at the same time, your employer would do the same and place another $10,000 from their pocket into your plan.
Effectively, with the above plan, without doing anything with your 401(k), you would already have a 100% gain on your $10,000. How’s that for providing a margin of safety?
Of course, not all companies would provide a dollar-to-dollar match (it could be 50 cents to a dollar or something) so do your part and check out the actual contributions applicable to you.
I did check the IRS website and there are other types of plans like the Roth and the 403(b), but I figured that the 401(k) is mentioned so often because it could be the most applicable (and effective) to majority of the population.
What can I do with the moolah?
Obviously, whatever that you (and your employer) have contributed to your 401(k) plan should do something, otherwise it’ll be idle and the returns would be worse off than putting your money in the bank.
In this case, the company could provide a few options for you to be vested. Typically, the money can be used to invest into a mutual fund (or a few, in fact), and with such, there might be a range of mutual funds for you to select from as well. It could be of different asset classes, like stocks or bonds. Profit sharing plans might also be linked to your 401(k) and could benefit the plan even more.
How is it different from the CPF?
So very different, in so many ways. To start off, it’s not compulsory! You always have a choice to opt out of your 401(k). Unlike in Singapore, CPF contributions are mandatory and at a fixed contribution rate across the entire nation. Even if you are self employed, you would still have to contribute to the Medisave account. Also, you can’t use your 401(k) money to buy your property. And yada-yada.
Okay, I get it. Wall of texts are boring. Here’s a consolidated table for the benefit of your eyes:
|Mandatory||Yes, as long as you have earned income of more than $20,000.||No, you can choose to participate or opt out.|
|Tax advantages||All mandatory CPF contributions are not taxable. Additionally, tax reliefs can be claimed on voluntary contributions up to a certain limit too. More details here.||Taxes are deferred on your contributions and only charged upon withdrawals.|
|Contribution limits||Employee contributions of up to $1,200 per month.||Up to $54,000 per year.|
|Withdrawal age||Age 55 – 65||Age 59 1/2|
|Investment options||Property, gold and other securities like mutual funds, stocks, bonds that are included in CPFIS.||Plans provided by employer such as mutual funds, stocks and bonds.|
Is taking up the 401(k) always the best option?
It really depends, since different plans are being offered in different organizations. You will have to make your own calculations to see if you can maximize the returns on your 401(k) together with your employer’s matching contributions.
For starters, as passive investors, you could check out the expense ratio of the mutual funds provided and choose one that is the lowest in cost, and preferably tracking an index to get instant diversification of your funds. Also, check if there are any additional administrative or annual charges involved which might impact your net returns over time.
So if I have a 401(k), does that mean I’m good for retirement?
I would like to see the 401(k) as something that you could use for diversifying the allocation of your funds. It enforces disciplined savings every month too, since you can’t get to touch that amount of money and there would be penalties for early withdrawal. Come to think of it, it is actually quite similar to an Investment-Linked Policy except that it might be lower in cost and also tax advantageous.
Here’s a link to another blog post of mine which has another link to a retirement calculator (blog-ception!). Have fun with it!
And yes, after today, I can finally read investment books with a peace of mind now, knowing what the 401(k) is. Hell yeah!
P.S. I apologize in advance if you find any information above untrue, and if it’s not too much to ask from you, please contact me via a comment below or email so that I can amend the mistakes. Although information was easy to find, I am not a US citizen so I might not be able to fully understand how you guys are being taxed over there. The same applies to Singaporeans/PRs on the CPF system!
Thanks for reading!
Miss Niao xoxo