The Five Stops Your 401k Money Makes

For the first four years I had a 401k I could not have told you a single thing it owned. I knew the balance, because the balance was on the homepage, and I knew it was going up, and I treated the rest as somebody else's department.

The rest is not somebody else's department. There are five stops between your paycheck and an actual share of an actual fund, and at two of them your money is just sitting there, doing nothing, which is a thing you are allowed to have an opinion about.

So let us follow one dollar.

Stop one: payroll takes it before you see it

Say you earn $80,000 and you elect 6%. That is $4,800 a year, or $200 out of each of 24 semi monthly paychecks.

In a traditional 401k that $200 comes out of your pay before federal income tax is calculated. On a 22% marginal rate, the rate applied to your next dollar of income, deferring $200 means your taxable income drops by $200 and your tax drops by about $44.

So the $200 in your 401k costs you about $156 of take home pay. That is the part nobody tells you, and it is the single most persuasive number in this whole article.

Two things still come out of that money regardless. Social Security tax and Medicare tax are calculated on your gross pay, so a 401k deferral does not reduce them. State income tax usually follows the federal treatment, but a handful of states do not, so check yours.

Worth knowing what you are actually electing. Most plans ask for a percentage of pay rather than a dollar amount, which is useful because it scales automatically with raises. Some let you set a dollar figure per paycheck instead, which does not.

If you never made an election at all, you may still be contributing. Automatic enrollment is common, and the default rate is often 3% of pay, which is set low enough that nobody notices it and is almost always below the level that captures the full match. On $80,000, a 3% default puts in $2,400 and earns a $1,200 match, against the $2,400 match available at 6%.

$1,200 a year, for a number somebody else chose for you.

Many plans also offer automatic escalation, which raises your percentage by one point a year until it hits a ceiling. It is a checkbox and it is the single highest return checkbox in the whole portal.

Stop two: it leaves the company entirely

This is the stop people get wrong. Your employer is the plan sponsor, which means they chose the plan, chose the menu, and pay some of the costs. They are not holding your money.

The assets sit in a trust with a custodian, and a recordkeeper, the company whose website you log into, tracks whose money is whose. Your balance is a claim on that trust, not a liability of your employer.

Which means if the company goes under, your 401k does not. That is the whole reason the structure looks so bureaucratic, and it is a genuinely good piece of design.

Stop three: the gap nobody mentions

The money leaves your paycheck on payday. It does not arrive in your account on payday.

The typical gap is a few business days, sometimes a week. There are legal deadlines on the employer to deposit it promptly, and a plan that routinely takes three weeks is worth an email to HR asking why.

It is a small thing, usually. But it is your money sitting in somebody else's operating account, and you are allowed to ask.

Stop four: it buys shares at whatever the price is that day

Your $200 arrives and is used to buy shares of whichever fund your election points at, at that day's closing price. If the share price is $112.40, then $200 buys 1.779 shares. $200 divided by $112.40 is 1.7794, and yes, you own fractions.

Nobody picks the day. You are buying on the 15th and the 30th whether the market is up or down, which is dollar cost averaging, putting a fixed dollar amount in on a fixed schedule, and a 401k gives it to you automatically whether you asked for it or not.

When the price is high your $200 buys fewer shares. When it is low it buys more. Over 24 paychecks a year for thirty years, that is 720 separate purchases and you will never think about a single one.

Stop five: the employer dollar arrives on its own schedule

The match is a separate deposit and it follows its own rules. Some plans deposit it every pay period. Some deposit it once, after year end.

Here is the trap. Say your plan matches 50 cents on the dollar up to 6% of pay, calculated per paycheck, and you decide to front load your contributions so you hit the annual limit by August. From September through December you contribute nothing, so there is nothing to match, and you have handed back four months of employer money.

Some plans have an annual true up that fixes this automatically at year end. Some do not.

Ask. It is one email and the answer is worth four figures.

Two things the plan can do with it that you might not expect

It can lend the money back to you

Most plans will lend you your own money. A 401k loan lets you borrow against the balance and repay it through payroll, with interest that goes back into your own account rather than to a bank. That sounds like a free lunch and it is not, because the borrowed money is out of the market for the whole repayment term and misses whatever it would have earned.

The part that catches people is what happens if you leave. An outstanding loan generally becomes due shortly after you separate, and if you cannot repay it, the unpaid balance is treated as a distribution, taxed as income and usually penalized on top. A $12,000 outstanding loan on a 22% rate can turn into roughly $2,640 of tax plus a $1,200 penalty, at exactly the moment you have no salary.

It may have a Roth side you have never looked at

The second thing is the Roth option. Many plans now let you send some or all of your own contributions into a Roth 401k, where you pay tax now and withdraw tax free later. The employer match has traditionally landed in the pre tax bucket regardless of which one you chose, though some plans now offer a Roth match too, so check rather than assume.

What thirty years of this looks like

Take the same numbers. $4,800 a year from you, $2,400 from the match, $7,200 going in annually. Assume 7% a year, which is an assumption and not a forecast, and let it run.

Read the last column twice. You and your employer put in $216,000. The balance is about $680,100.

$464,100 of that never came out of anybody's paycheck. It is return on money that was already in the account, which is the entire argument for starting early and the reason a year of delay is expensive in a way that does not feel expensive at the time.

The two limits people confuse

There is a cap on what you can defer from your own pay each year. There is a separate, larger cap on everything that lands in the account from all sources, which includes your deferral, the employer match and any additional employer contribution.

The distinction matters because people hit the first one and assume the account is closed for the year. It usually is not. The match keeps arriving if the plan has a true up, and some plans allow after tax contributions above the deferral limit up to the total cap, which is a lever most participants never discover.

Say the deferral limit is $23,000 and the total limit is $69,000. Your $23,000 plus a $4,800 match is $27,800, leaving room under the second cap that only exists if your plan permits after tax money.

There is also a catch up allowance once you pass a certain age, which raises the deferral limit for older workers.

The fees come out of the share price, not your bank account

You will never see a line item that says fee. The expense ratio, the slice the fund takes every year for running itself, is deducted from the fund's assets daily, so it shows up as a share price that is very slightly lower than it would otherwise have been.

The fund I was in charged 0.71%. On a $40,000 balance that is $284 a year, every year, whether the fund goes up or down.

There is often a second charge on top, a plan administration fee that pays the recordkeeper. Sometimes it is a flat amount, maybe $45 a year billed as $11.25 a quarter. Sometimes it is another 0.15% of your balance, which on $40,000 is $60. Both are disclosed, in a document called the participant fee disclosure, which arrives once a year and which I would bet you have never opened.

The two numbers to go get

Log in. Find the name of the fund your money is currently in, and find its expense ratio. That is it, two numbers, and they are usually on the same screen.

It took me six minutes and I did not like the answer. But I could not have fixed anything before I had it, and the difference between 0.71% and 0.04% on a balance you will hold for three decades is not a rounding error.

It is closer to the price of a car.