One of the BEST way to save on taxes: What is a 401k

What's up you guys, it's Graham here. So, due to popular demand from a video I made about a week ago about why you should open up a Roth IRA, I'm going to make this video to share with you guys one of the best ways to reduce your taxable income and one of the best ways to save a lot of money on your taxes.

This is also one of these videos that's so important to watch all the way through. Seriously, give it a chance; I promise it's going to be worth your time. If not, if you get to the very end and you just like have made up your mind that I just wasted 10 minutes of your time, seriously, just click the dislike button, and I deeply apologize. But I highly doubt that's going to be the case. It's a really important topic, and at least give it a chance. We can't have anyone freak out out there, okay? You've got to keep our composure.

So, with that said, I'm going to be sharing with you guys exactly what a 401k is, how it works, and some of the pros and cons of having it. To start, I actually had no idea what a traditional 401K was until I was like 20 years old. Until then, I literally just thought it meant $401,000. I was an idiot! But what it actually refers to is section 401K of the IRS tax code, which authorizes company-sponsored retirement plans.

So, the 401K was started in 1978, and the entire intention of it was just to defer employee-earned income into retirement. So, how does it work? Well, it's fairly simple. You can contribute up to $18,000 per year into the 401k account, or up to $24,000 per year if you're over the age of 50. Again, it's pretty simplistic: the money you put in the 401k account is not taxed right now, but instead, it's taxed after the age of 59 and a half when you begin withdrawing the money from the account. Hopefully, you'll be in a lower tax bracket then than you are right now today.

So, here's a totally simplified example. Let's say you make $100,000 this year, and of that, you contribute $18,000 to a 401k. Contributing that $18,000, assuming you're in a 25% tax bracket, is going to save you about $4,500 in taxes. Now, by doing this, you have an extra $4,500 upfront right now that you can invest that's going to work for you for the long term.

By the time you hit retirement age, after 59 and a half, you begin taking your money out. The money then at that point in the future is going to be taxed as ordinary income. The biggest advantage here is that you can invest all your money completely pre-tax and have all of that working for you. So, that extra $4,500 can grow to something substantial because you wouldn't have had that to begin with; you would have just ended up paying that upfront right now in taxes.

As an example, because of taxes, if you wanted to invest that same $18,000 but in a Roth account—which again is all done after taxes are taken into consideration—you would need to earn $24,000 to have $18,000 left over after taxes, just assuming you're in a 25% tax bracket. Now, with a 401k, $18,000 is just $18,000 because you haven't paid any income tax on it yet. So, that $18,000 that's invested in 401K could be worth a lot more money than just $18,000; it just hasn't been taxed yet.

Then, once you reach the age of 59 and a half, you can begin withdrawing all this money from the account. Now, the catch is, because you haven't paid any taxes on all of this money, you pay tax on the money that you withdraw as if it's ordinary income. But the advantage here is you've had a lot of pre-tax money working for you. So, in that $18,000 example, for instance, you've had an extra $4,500 invested that's compounding interest, making you even more money that you can then draw from in the future.

And again, like I said, you're betting that the tax bracket when you retire is going to be less than what you're paying in taxes right now, and you could just profit the difference. So, how do you go about doing this, and how do you go about setting it up? Well, if you're employed, it's as simple as going and asking your employer if they offer a 401k plan. If they do, look into setting one up and contributing to it. Sometimes your employers will also offer what's called an employer match, which means that they'll match a certain amount of money that you put in the account.

Anytime they offer this, absolutely do it 100% of the time because it's pretty much like getting free money. If your employer offers a 401k match, seriously, just do it. For instance, if you put in $1,000, your employer will also match another $1,000. It's free money! Please, go ahead and do that if your employer offers it. If they don't, it's not the end of the world, but anytime they do, take advantage of it.

Now, the downside here is that if your employer doesn't offer you a 401k option, you might be out of luck. Instead, it might be better for you just to contribute to an IRA. Now, if you're self-employed like I am, you have the option to set up a SE 401k account, or it's sometimes also called a solo 401k account. This allows you to contribute as both the employer and the employee up to $54,000 per year. I highly recommend doing this if you're self-employed; it gives you a lot of flexibility.

I personally use Vanguard with a total stock market index fund for all of my investments in a SE 401K, but of course, you're free to do your own research and invest wherever you feel the most comfortable. Now, if you're not employed or you're a student, or you just have some side cash coming in here and there, don't worry about it. It might just be best at this point to open up a Roth IRA but keep the 401K in mind for the future.

So, now is the question: when is it the right time, and when should you contribute to a 401k? Generally speaking, it's better for you to invest in a 401k if you're making a lot of money right now and you're in a high tax bracket, and you intend to retire with less income in a lower tax bracket. In that situation, it makes sense to take the upfront tax deduction now, have extra money working for you, making you even more money. Then, when you retire in a lower tax bracket, you profit the difference, like I said, from what you would be paying right now and what you would be paying in the future when you're making less money.

You're going to hopefully be in a lower tax bracket then. This would give you a lot more money upfront to invest as opposed to a Roth IRA, for instance. But now, generally speaking, if you're young right now and you're not earning as much money as you plan to be making in the future and you plan to be retiring with a lot more money in the future than you have right now, maybe a 401k probably isn't the best option for you, and instead, you're better off looking into a Roth IRA.

However, unlike a Roth IRA where you can withdraw all your contributions tax-free prior to the age of 59 and a half, with a 401k, you can't do this because all of the money you've already put in there is pre-taxed; it hasn't been taxed at all. So, if you take any of it out, you're subject to a 10% penalty, plus you have to pay the taxes you would have paid on it. So, I just recommend instead if you put money in a 401k, chances are it's best to leave it there, don't touch it, forget about it, and then deal with it when you're a lot older.

So, with all of that said, let's now discuss a few of the potential downsides of investing in a 401k. The first downside is just the lack of liquidity. You put your money in there and it stays there until you're 59 and a half. That's a very long-term investment. At least with the Roth IRA, if you put $5,000 in that account, you can always take that $5,000 back out at any time without a penalty. But with a 401k, any money you put in there, like I just said, is subject to a 10% penalty, plus you pay taxes on top of that if you take it out prematurely.

Now, for someone like me, I really value the liquidity of having cash on hand because my primary investments are usually real estate. So, I like having the extra cash on hand that I can use at any time to invest in real estate and buy something that cash flows. Having a 401k for me and investing a huge amount of money in the 401K right now doesn't necessarily make sense. I do put some money in the account, but predominantly for me, it's all invested back into real estate.

The second downside I see is that your employer could be charging some really high fees in your 401k account. So, for instance, if they're charging you like 2% annually for the 401K plan, that could dramatically reduce your returns and make it a lot less appealing. So, before you invest in a 401k plan, find out what the fees are. If they're going to be absurdly high, at least know that going in so you could adjust your expectations. Maybe it's not as worthwhile as what you thought.

The third downside I see with a 401k account is that you could potentially retire in a higher tax bracket. I know for me, for example, I don't want to retire earning less money. If everything goes well and everything goes to plan for me, I definitely like to retire with a lot more money than what I have right now, which means the taxes I'm paying now are actually going to be less than the taxes I'm going to be paying when I'm like 60 years old.

So, it just depends on your situation. If you're someone who wants to save up a certain amount of money and then go off and just retire at whatever age, then maybe this is the right option for you. But if you're planning to retire with a lot more money in the future, then definitely take that into consideration that there's a chance you just end up paying more taxes in the future than you would have paid just today.

The fourth downside I see is that your money is subject to some market risk. And again, I mean, this is pretty much unavoidable. It's the same thing with the Roth IRA, but it's something definitely worthwhile to mention because, by your money being invested, there is some risk involved in that. Yes, there is a chance that your returns aren't going to be as good as they have been historically. There's a chance that you might lose some money short-term. So anytime you invest money, there is some risk. In a 401k, this is certainly no exception.

By the way, I'm going to be making a future video about all the risks of investing and putting the money in the stock market and real estate, so definitely stay tuned for that. Now, with all of that said, what's my recommendation? Now, my personal philosophy is just do a little bit of everything. Invest in a 401k, invest in a Roth IRA if you want to, do real estate, invest in real estate if you want to, buy a business, buy a business.

Do a little bit of everything. At the very least, that's going to give you a lot of options in the future because the truth is none of us really know what the tax system is going to be like 20 or 30 years from now. It may be in our favor; it may not. Sometimes our WTH is going to be better; sometimes it's not. Sometimes a 401k is going to be better; sometimes it might not. We don't know any of these things, and there are so many variables.

So, my personal philosophy and recommendation is just to do a little bit of everything and diversify a bit. Don't put all of your eggs in one basket. That could work out amazing for you, and you could make like a ton of money, and that's great! Or there's a chance you risk a lot of that. Maybe it doesn't work out as well as you had planned. For me personally, I probably just invest a little bit in everything. That's the route that I would take.

So, because everyone always wants to know too what I do: I have a Roth IRA invested in an S&P 500 Index Fund with Vanguard, and then I have a 401k invested in that same fund. Then, honestly, the majority of my money is just thrown in real estate investments. That's where the majority of my money goes—it's all real estate. But for me, the Roth IRA, just throw money in that, the 401K, just throw some money in that too. At least I have it scattered around; even though the majority of my money is still in real estate, at least I have some other options to choose from in the future.

So, with that said, I really hope you enjoyed this video. Like, my fingers are crossed you didn't hit the dislike button! I hope you found some value in this. This is really just meant to be an introduction to a 401k and what it is, and some of the pros and cons of it so that you can begin to do some more research and see if it's right for you. If you're into it, if you liked it, and you want to see more of these types of videos, make sure you're subscribed. I'm going to be releasing a lot more videos in the future.

I'm also in the process of buying some more real estate, so I'm going to be covering all of that, like the whole remodeling process and everything. So, if you want to stay a part of that, stay tuned and keep up to date with that. The Subscribe button is right there. Also, feel free to add me on Instagram and Snapchat; I post there pretty much daily. So if you want to be a part of that too, you know how to find me on there.

Thank you again for watching! I seriously, like I said, I have so much fun making these videos and like nerding out with finances, sort of topics, and talking about money and all that sort of stuff. So, I really enjoy this, and I hope you guys enjoy it too. Thank you again for all of your support, and until next time.