What is a 401(k) and How Do They Work? - YouTube

Hey everyone, Andy here with Twisted Finances in  today's video we are going to talk about what a  

401k is and how they work. I will also be covering  how 401k contributions work, the different types  

of 401ks, how much you should contribute into a  401k, and also how withdrawals of a 401k work.  

So be sure to watch the entire video so you  know the ins and outs of the most important  

retirement vehicle that you have at your disposal. So, a 401k plan is a tax advantage retirement plan  

also known as a defined contribution retirement  plan that is offered by most employers in the  

United States. You, as an employee, can elect to  have your contributions automatically taken out  

of your check either pre-tax or post-tax,  and most times your employer will actually  

match your contribution up to a certain limit. The investment earnings from the pre-tax 401k,  

which is also known as a traditional 401k, are not  taxed until you withdraw that money in retirement.  

And the investment earnings on a post tax 401k,  also known as a Roth 401k, are tax-free earned  

even through retirement because you already  paid the tax on the money when you contributed. 

So like I mentioned before there are two different  types of 401ks, you either have a traditional  

or a Roth 401k. The main difference between  the two is just how they're taxed and we'll go  

more in depth between traditional and Roth 401ks a  little later in this video. I just wanted to kind  

of cover it real quick. And whether your employer  actually provides a Roth 401k is really different  

between all employers. Roth 401ks are seeing an  increased amount of availability with employers  

so they are becoming more known but, there are  still a lot of employers that just only provide  

traditional 401ks, which is fine, it's still good. So now that you know really kind of what 401ks are  

and kind of how they work  let's kind of look at the laws,  

regulations, and the contribution strategies. So the IRS sets a specific limit on the amount  

that you can contribute into your 401k. For 2021,  the 401k contribution limit for anybody under 50  

is $19,500. For employees that are older  than 50, the contribution limit is $26,000  

because the IRS allows what they call a  catchup. Basically since you're getting  

close to retirement you're allowed to fund more  in your retirement because you probably need to. 

In the last few decades 401ks have really  just blossomed and become this powerhouse and  

really the most important retirement vehicle that  Americans have. Back in the day we used to have,  

well I say we but, they used to  have traditional pension plans,  

also known as defined benefit plans, where the  employer was basically solely responsible for  

contributing into this plan and making sure that  once their employees retired then they would have  

amount of money coming in for x amount of years.  Then in came the absolute turbulation of 2008 in  

the market crash and businesses went bankrupt,  pension plans went bankrupt, and there were  

hundreds of thousands of people that were left on  the street with no job, no pension because it was  

mismanaged. And it was just... it was a great  idea ran by *BEEP* idiots and just *BEEP* so  

many people over so pension plans are really hard  to come by if you're a non-government employee. 

So this means that the duty of preparing for  retirement has fallen back on the employee.  

So this is something that you really need  to understand so that you can live at least  

a decent retirement or sustain the same cost of  living in your retirement. You have to understand  

these things, if you don't then you're *BEEP*. But not only are employees responsible for  

setting aside the money for contributing into  their 401k, they're also responsible for picking  

out the investments in their 401k. Now, most  employers' 401k administrators will give you some  

financial advice or they might have a specific  plan that they suggest to all their employees  

to invest in. I kind of prefer to choose my own  investing because I feel like I have more control  

over it and I don't want to take somebody else's  word on what I should invest and not invest. 

And this is really an area where you can just  make your 401k shine, if you're young you should  

especially just throw all of your money into  high aggressive growth funds that have low  

expense ratios. You've got so many years before  you use this money if it tanks, it tanks, it'll  

go back up and you're fine. And I know choosing  different investment vehicles inside of your 401k,  

and understanding 401ks, it's confusing man.  Like, I went to school, I got a degree in  

accounting and finance and when I first set up  my own 401k I was like dude.. "what the *BEEP*  

is all this?". Like why don't they teach this  stuff throughout our lives? It's so important,  

it blows my mind, but that's for a different day. To not overwhelm you with all of the things that  

go behind your 401k, the best practice is is  just to look at your 401k available investments  

and then look at the 5 to 10 year performance  along with the expense ratios, and you can kind  

of pick and choose the best performing ETFs  or investment vehicles inside of your 401k. 

At the end of the day you're going to have  to do a lot of research but I'm telling you  

this research is a must because it can make  a difference of tens, maybe even a hundred  

thousands of dollars by the time you retire. So now that you kind of know how contributions  

work with a 401k, so how much should you  contribute into your 401k? A lot of people  

get this mixed up and think that they should just  contribute 15% 20% of their pre-tax dollars into a  

401k, that's really not the best option to do. This is not financial advice, however,  

it is a financial advisory standard and something  that I do in my own personal life. Only contribute  

up to what your employer matches so if your  employer matches up to 5%, contribute 5%. If your  

employer matches up to $5,000, contribute $5,000.  That's free money it's literally additional salary  

that you're getting paid just for contributing  to the 401k. Free money take that [ __ ] and run. 

Now, you might be asking me why don't  you contribute more into a 401k?  

Well honestly I think that the money is best  used in a IRA, specifically a Roth IRA. There  

are more options that you have with an IRA than  you do with a 401k because your 401k only has  

a specific listed amount of investments, IRAs have  a whole stock market at your disposal. So I just  

think it's better and I think it's more beneficial  by the time that you retire if you have more money  

in IRA than a 401k especially, a Roth IRA. That's  me personally, once again not financial advice  

just what I do personally. It works for me, I  think it's a great idea, you might not think it's  

a great idea, you might want to contribute more in  your 401k that's fine. I'm just here to give you  

the facts and let you know how this [ __ ] works. Hey real quick, if you're enjoying this video or  

if it's provided any value to you or answered  any of your questions I'd really appreciate if  

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thank you so much, let's get back to the video. Okay, so now let's talk about the two different  

types of 401ks: Traditional 401k and the  Roth 401k and, like I said earlier, the only  

difference between the two is how they are taxed.  Traditional 401ks are used with pre-tax dollars  

so you're not going to get taxed on the amount in  that account until you withdraw it in retirement. 

The traditional 401k is best for somebody  that is in a high tax bracket right now  

and predicts that they're going to be in  a lower tax bracket by retirement. So,  

for example, if they're 40% tax bracket right now  they're saving 40% on the contribution and then  

in retirement if they think they're going  to be in the 20% tax bracket then they're  

effectively saving 20% in taxes. Traditional  401ks are the best option for high income  

employees because they reduce your taxable income. On the other hand, Roth 401ks are invested with  

post-tax dollars and Roth 401ks are the best  option if you think that you will be in a  

higher tax bracket come retirement. Because, by  the time you retire, everything in your 401k,  

every single dividend you receive, every single  capital appreciation, is completely tax-free  

completely tax-free. And I know a lot of people  don't like me saying tax-free because "it's funded  

with post-tax dollars you paid tax on it" well  if I'm in a 10% tax bracket and so I'm paying  

10% on my contribution and then when I retire I'm  in a 40% tax bracket... like it it nets out it's,  

it's tax free like stop being so anal about it. But aside from my rant, I do apologize,  

Roth 401ks are the best for particularly younger  professionals that are just now starting out,  

they're in a low tax bracket because they're  in the entry-level jobs so they're probably  

already generating a refund on their tax  returns so there's really no reason why  

they should decrease their earned income  anymore, they should just invest it. 

So now that we basically know everything that you  need to know about 401ks and all of the beautiful  

pretty grasses green on the other side things  let's look at the [___] that sucks with 401ks  

and that's the withdrawal laws for 401k plans. Now most people aren't going to touch their  

401k until retirement but there are some people,  and I've actually withdrew amount from my 401k  

this year just because I have certain tax credits  lined up and I've been generating a refund for the  

past five or six years so the penalty and all the  taxes which will cover, um it's not a worry to me. 

But anyway let's cover withdrawals  on the Roth 401k first. 

So with a Roth 401k you are allowed to withdraw  up to the amount that you've contributed into the  

account without incurring any tax or penalty. So let's say that your Roth 401k,  

you've contributed into it $10,000 and the balance  from dividends or capital appreciation is $12,000. 

You can take out up to $10,000 but  you cannot touch the extra $2,000. 

If you were to take out the entire $12,000 then  you are therefore going to be penalized 10%  

on the extra $2,000 which would incur  a $200 early withdrawal penalty. 

On the other hand we have traditional  401ks, and they are a different type  

of beast when it comes to withdrawal. The early withdrawal penalty is the same as  

a Roth 401k, the 10% penalty, however since it is  funded with pre-tax dollars, any amount that is  

withdrawn from that account you must pay taxes. So let's take the example that we used before  

with a traditional 401k balance of $12,000. If you  were to withdraw the entire amount you would incur  

a 10% penalty on the whole  $12,000, which is a $1,200. 

And, upon withdrawal the 401k administrator,  whether it's Fidelity or John Hancock,  

is required to withhold 20% for federal  withholding on the entire amount. 

So if your balance is $12,000 in a traditional  401k and you withdrew all of it you would only  

actually receive $9,600 because $2,400 is going  to be withheld for federal taxes. And then come  

tax time, you will be levied an additional 10%  penalty, the $1,200, on your early withdrawal. 

So in total it's about $3,600 on $12,000 that  you will have to pay for your early withdrawal. 

I know I know taxes, taxes, taxes. If you didn't  know I'm actually a tax reduction advisor and I  

kind of know this stuff because I deal with it all  the time. So if you have any specific questions  

in terms of taxes let me know down in the  comments and I'll be able to clear those bad  

boys up because it can get kind of confusing and  a little sticky sometimes. But the best advice  

that I can give to you if you're contemplating  withdrawing from your 401k is to make sure that  

you have some credits lined up or your income is  low maybe like child tax credit education credits  

anything like that that can help cover your ass  come April 15th so you don't have to pay more. 

But anyway thank you guys so much for  watching the video I really do hope  

you enjoyed it I hope it provide value I hope  it answered any questions like I said before  

any additional questions or specific questions  that you may have just let me know down in the  

comments I'll bang them out I'll help  you out that's what we're all here for  

don't forget to smack that like button right on  the ass and don't forget to subscribe if you're  

interested in having weekly financial content that  can help boost your financial literacy to make  

you one step closer to financial freedom thank  you guys again so much I'll catch you next time