One of the most common ways people save for
retirement is by contributing to a 401(k), a retirement savings account offered by many
employers. So, what is a 401(k), and how does it work? We’ll look at three main concepts: contributions,
investments, and account management. But first, let’s start with the absolute
basics: the name. It’s called a 401(k) because of the section
of the IRS code that sets out the rules for this type of account, section 401, subsection
k. Basically, the government allows companies
to offer retirement savings accounts with certain tax advantages in an effort to encourage
people to save for retirement. Tax advantages are one of the main benefits
of contributing to a 401(k). When you sign up for a 401(k), you’ll set
an amount or percentage to be automatically taken out of each paycheck to fund the account. With a traditional 401(k), the amount you
contribute is deducted from your taxable income. Let’s say you earn $100,000 per year and
contribute $10,000 to your 401(k). That means your total taxable income for the
year would be $90,000, reducing the amount you have to pay taxes on that year. In addition, the money you contribute to a
401(k) and then invest can grow tax-deferred, meaning you don’t pay taxes on it until
you withdraw it in retirement. In the meantime, the money in the account
can compound without being taxed. Some employers also offer a Roth 401(k), which
allows you to contribute after-tax dollars. Instead of decreasing your tax burden now,
this allows you to take the money out tax-free during retirement. Only you can determine which 401(k) is right
for you. It depends on several factors, like how much
you expect to earn later in life and whether you want tax benefits now or later. Some people choose to contribute to both. Talk to a tax professional for more information. 401(k) tax benefits have some limits. The money you put in a 401(k) should be treated
as basically untouchable until you turn 59 and a half. Typically, if you withdraw money before then,
you’ll face an early withdrawal penalty and income tax unless you qualify for one
of the few exceptions, like paying for substantial medical expenses or disability. Overall, it’s best to avoid jeopardizing
your retirement savings with early withdrawals. The IRS limits how much you can contribute
to a 401(k) each year. These limits rise with inflation and can depend
on your age, so it’s best to check with the IRS or a tax professional. Another major benefit of participating in
a 401(k) is that some companies offer a match. That’s extra money the company contributes
to your account just for participating, and it doesn’t count toward your individual
limit. So, say, your employer matches 50% of all
your contributions up to 6% of your annual salary. This means if you make $50,000 and you contribute
6%—that’s $3,000—your employer would contribute $1,500 on top of that. If your employer offers a match, be sure to
contribute enough to get the maximum amount. Don’t leave free money on the table. Keep in mind, some companies have what’s
called a vesting period. That’s the period of time you have to work
there before the money the company contributes becomes fully yours. Check with your employer to learn more about
your company’s policy. Now that you understand contributions, let’s
talk about choosing investments. 401(k)s typically offer a limited number of
investments, like mutual funds or exchange-traded funds. If you find the number of investment choices
too limited, see if your employer offers a self-directed 401(k). These plans may provide additional investment
choices. Either way, you’ll have to weigh the risks
and fees associated with each investment. It’s generally best to not take the money
out until you reach retirement age, so focusing on long-term investing rather than quick profits
might be a prudent choice. When managing your account, be on the lookout
for the drawback of 401(k)s: fees. Some 401(k) providers charge additional administrative
fees on top of the cost of individual investments. These fees are not always obvious, so check
with your plan administrator or use an online 401(k) fee analyzer. If you’re unhappy with the fees you’re
paying, you can consider other retirement accounts like Individual Retirement Accounts,
or IRAs. Even if your 401(k) offers limited investment
choices or charges high fees, you should still contribute enough to get the maximum match
from your employer. The match typically outweighs these drawbacks. Over time, you’ll likely work for several
companies, which could mean you might have many 401(k)s. So, what do you do with those old accounts? You can often combine them into your current
401(k) or an IRA through a process called a “rollover”. This allows you to move funds directly from
one retirement account to another without incurring tax penalties. Keeping your retirement savings in fewer accounts
may make them simpler to manage. The 401(k) is one kind of retirement account,
but the tax benefits and potential employer match make it a powerful way to invest for
the future. Contributing to a 401(k) is one of the simplest
ways to “pay yourself first”.
