Lesson four: types of investment accounts?
When I started my first “grown-up job” after finishing university, I got a stack of paperwork to go through. One of the things HR mentioned was about signing up for the company 401k, their employer match, and the vesting schedule.
“Uh, what?” I thought.
I had heard various times, in passing, about “the 401k” and how it was a beneficial account to take advantage of. However, even after reading over the paperwork for it at my job, I still had no freaking clue how exactly it worked.
What the heck was a “vesting schedule?”. From the list of investment options I got, which one was the best fund to choose?. It was all so confusing.
Well, thankfully now, I know a lot more about not just 401k’s but lots of different types of investment accounts. Let’s go through and understand them.
401(k) / 403(b) / 457(b)
These are employer-sponsored tax-advantaged retirement accounts. You can only gain access to them by working for an employer that offers them to their employees.
401(k)’s are offered by for-profit businesses.
403(b)’s are offered by schools, hospitals, churches, and certain 501(c)(3) tax-exempt organizations.
457(b)’s are offered by certain state and local governments and tax-exempt nongovernmental entities.
These types of investment accounts come with tax advantages. A common tax advantage is that by diverting some of your paycheck into the accounts, you reduce your taxable income for the year.
This happens when you contribute to a Traditional 401(k), which is when your contributions are made before taxes. You only get taxed upon withdrawal.
Example of contributing to a Traditional 401(k)
Someone is working a job with a $50,000/year salary. If they have 6% of their paycheck going into their workplace 401(k) plan all year long, then their taxable income in the eyes of the IRS is $47,000 for the year.
Employer match (free money…with a catch)
Buckle up for the following explanations. Employer-sponsored 401(k) plans can be confusing with their different structures.
Let’s start by talking about an employer 401(k) match. A 401(k) match is when your employer contributes money into your 401(k), based on the contributions you’ve made out of your compensation.
Employers either do a partial match up to a certain percentage of your compensation or a full match up to a certain percentage of your compensation. Let’s see some examples of how that could look.
Example of a 401(k) employer match
Your employer contributes 50 cents for every dollar you contribute to your 401(k), up to max 6% of your compensation.
Essentially, they’re giving you a 3% dollar for dollar 401(k) match.
Leslie is getting paid $50,000/year and contributing 6% of her paycheck to her 401(k), she would be contributing $3,000 for the year and her employer match would be $1,500.
A 401(k) employer match is part of your total compensation
A 401k/403b/457b employer match is often touted as “free money”. I would more so describe it as part of your total compensation package. You should definitely take advantage of an employer match if your job offers one.
Some people get apprehensive about having less take home pay due to contributing into a 401k plan. However, by not contributing to a 401k plan that offers an employer match, you are turning down additional money. You’re effectively taking a pay cut at your job.
Many financial advisors and personal finance influencers recommend always taking advantage of an employer match, even if you have debt to pay off or other savings goals. Because taking advantage of an employer match means you’re getting a guaranteed rate of return on your money from it.
Vesting schedule
The reason I'm apprehensive calling an employer match “free money” is that it usually comes with a stipulation: a vesting schedule.
Your 401(k) contributions are always 100% yours. However, the employer’s matching contributions might come with a vesting schedule. This means you won't get to keep 100% of those employer matches until after a set time frame passes.
There are two kinds of 401(k) vesting structures: cliff based vesting and graded vesting.
Cliff-based vesting & graded vesting
Cliff vesting occurs when an employee becomes fully vested in an employer-sponsored investment account on a specified date rather than becoming partially vested over an extended period.
The longest an employer can stretch cliff based vesting is three years. After three years, they are required by law to start letting you become partially vested in employer matching contributions.
Graded vesting is where employer matching contributions become partially vested at certain time frames. The employer is required by law to have their matching contributions be fully vested by six years of employment.
Here are a few examples of how cliff based vesting and graded vesting can look
Cliff-based vesting
0% vested until three years employment. After three years, 100% vested.
Graded vesting
Four years with a one-year cliff:
25% vested after one year employment
50% vested after two years employment
75% vested after three years employment
100% vested after four years employment
What happens to your 401(k) when you change jobs?
When you leave your job, there are four options on what to do with your 401(k).
Transfer it to your current employer’s 401(k) plan
Roll it over to an IRA
Leave it where it is
Cash it out
Transferring your previous workplace 401(k) plan to your current workplace 401(k) plan
There is the option of transferring your old 401k plan into your new job’s 401k plan. This allows you to consolidate and keep the number of accounts you have to a minimum. This can be a good option if your current 401k plan has low fees and you like the investment options.
Some employers have a minimum time period from date of hire to date of 401(k) eligibility. Check with your HR department on this. Once you are eligible for your current job’s 401k plan, you contact your old 401k provider and they will either deposit the money into your current 401k account or they will mail you a check for you to deposit.
Many high income earners choose to do this option, rather than rolling their old 401k into an IRA, because it keeps the option open of doing a Backdoor Roth IRA in the future. I won’t go into much detail about this because it doesn’t apply to many people and it’s more of an intermediate investing topic. However, you can learn more about Backdoor Roth IRAs by clicking here.
Roll old 401(k) into an IRA
IRA is an acronym for Individual Retirement Account. It’s a tax-advantaged retirement focused investing account you can open on your own, no employer necessary.
Compared to 401(k)’s, IRAs have more flexibility. They usually have lower fees and unlimited investment options. If the thought of having to pick your own investments and manage them yourself sounds anxiety-inducing, depending on the IRA provider, you usually have the option of choosing an “automated IRA”. This is sometimes referred to as a robo-advisor. This means the brokerage holding your IRA account, will select investments and manage rebalancing for you, based on some questions you answer about your goals and time horizon.
Leave your 401(k) with your previous employer
This is the easiest option since it requires no effort on your part. Although, that doesn’t necessarily mean you should do it.
Your 401k with your previous employer could have high fees and limited investment options. If so, it would probably be in your best interest to not leave it where it is.
Nowadays, most people have several jobs over the course of their multi-decade working life. I don’t know about you, but I wouldn’t want to have 5-10 401k plans scattered around in different places.
Cash it out
It is strongly recommended by many to NOT cash out your 401k. Since the 401k is an account intended for retirement, it’s meant for you to use after age 59.5 or older. If you take money out before then, you’re subject to a 10% penalty, in addition to the ordinary income taxes you would pay on the money.
Let’s see an example of how that may look. Let’s say you have a 401k with a small balance of $5,000.
“It’s only $5,000! That’s nothing for retirement. I could use that money now!” you exclaim.
After the 10% early withdrawal penalty and ordinary income taxes. This is for someone who has income in the 22% tax bracket For tax year 2024, the 22% tax rate is for the portion of income between $47,151 - $100,525.
As you can see from the image above, if someone (in the 22% tax bracket) were to take $5,000 out of their 401k, they would only net $3,400 from the withdrawal.
But wait! It gets worse. Not only do you pay a penalty for withdrawing your 401k money early, that money won’t get the benefits of compound interest.
Let’s say you’re a 25-year-old who plans to retire at age 65. If that $5,000 had been left in your 401(k), after 40 years, at age 65, it would have grown to $157,047 (assuming a 9% average rate of return. The U.S. Stock Market has 8-10% long term average returns).
These are just accounts, not investments
401(k), 403(b), 457(b) are just accounts that hold investments. They are not investments themselves. Once you have one of these accounts set up, your HR department usually will give you information on your workplace savings plan, which includes details about investment options.
Picking 401(k) investments
These accounts vary wildly from one employer to the next, so it’s difficult to give insight into picking investment funds. In my experience, a good resource I have found is the r/personalfinance subreddit on Reddit.
When I was an investing newbie, I took a screenshot of the investment fund options for my workplace 401(k) and made a post inside r/personalfinance. I got several answers that said the same thing: choose the fund that mirrors the S&P 500 or one that encompasses the Total U.S. Stock Market.
There were also several answers about what to keep in mind when choosing 401(k) investments
Look for funds with low expense ratios (as close to zero as you can get!)
See if there is a Total U.S. Stock Fund and a Total International Stock Fund (a simple, diversified two-fund portfolio)
See if there is a low fee target date index fund with a year around when you turn 70 (2060 fund, 2065 fund, etc)
I kept all these things in mind when I looked over the funds list of my 401(k). I did end up finding a fund that tracked the S&P 500, the Fidelity 500 Index Fund, which had the ticker symbol: FXAIX. I also chose an international fund called the Fidelity Total International Index Fund, ticker symbol: FTIHX.
I set up auto-investment into that fund for my workplace 401(k) and called it a day! Everything had now been setup and automated.
401k's often have large cap, mid-cap, and small-cap fund options to choose from, amongst other options such as target date funds.
Large cap: stock shares of the companies with a market capitalization of $10 billion or more. Established companies with high dividend payouts. (Microsoft, Apple, Nvidia, Google, Amazon, Meta, Tesla, etc)
Mid-cap: stock shares of companies with a total market capitalization in the $2 billion to $10 billion range.
Small-cap: stock shares of companies with a total market capitalization in the $300 million to $2 billion range.
Example investment funds
Vanguard Total U.S. Stock Market Index Fund ETF (ticker symbol: VTI): A low fee index fund ETF containing large-cap, mid-cap, and small-cap equities. 3,704 stock holdings. The fund's goal is to track the total return of the entire U.S. stock market.
Fidelity Total U.S. Stock Market Index Fund (ticker symbol: FSKAX): A low fee index mutual fund containing large-cap, mid-cap, and small-cap equities. 3,853 stock holdings. The fund's goal is to track the total return of the entire U.S. stock market.
Schwab Total U.S. Stock Market Index Fund (ticker symbol: SWTSX): A low fee index mutual fund containing large-cap, mid-cap, and small-cap equities. 3,354 stock holdings. The fund's goal is to track the total return of the entire U.S. stock market.