Many employees need clarification on what their employer’s retirement plan entails. They may also need clarification about what types of investments they should select and the rules surrounding 401(k) withdrawals. Employers often match employee contributions dollar-for-dollar. It’s important to take advantage of this benefit, says Golladay. Aside from this, consider your risk tolerance and invest in a portfolio that fits your needs.
What is a 401k?
Employees can invest a portion of their wages in a 401(k) plan offered by their company, subject to IRS and plan restrictions. Unlike traditional pension plans, where employers promise a monthly income at retirement, a 401(k) plan gives workers control over when they start receiving their benefits. In addition, employee contributions may be matched by their employer, and withdrawals are taxed only upon distribution at retirement age. Investing in a 401k retirement plan is an effective way to save for retirement, especially if the company matches your contributions. Depending on your current salary and retirement years, your savings account size can grow significantly through compounding returns over time. However, the impact of your investment strategy and the market can vary from person to person, so it’s important to work with a trusted financial advisor. When you sign up for your employer’s 401(k) plan, you can select mutual funds and other investment alternatives as your investments. Your chosen funds are based on your situation, goals and risk tolerance.
In addition to the options you choose, knowing what happens to your 401(k) when you change jobs or retire is important. You’ll want to carefully weigh your alternatives to avoid potential fines, whether you transfer your funds from the previous plan to your new workplace’s 401(k) or an IRA.
How does a 401k work?
Employers sponsor 401(k) retirement savings programs, which offer tax advantages to participants. Depending on the type of account, pre-tax contributions and investment earnings are tax-deferred until withdrawal, typically after retirement. In addition, the ability to defer income taxes can benefit employees in a higher tax bracket now than when they expect to be in retirement.
In addition to tax-deferred gains, 401(k)s offer other benefits such as automatic paycheck deductions and employer matches. Most employers offer a match of employee contributions, a percentage of the money contributed by an employee, up to a set limit. Investing in a 401(k) is a great opportunity to use compounding. Compounding is earning interest on the original amount invested and any accumulated interest. Its added power can significantly impact your long-term investments, especially when you open your 401(k) early and have the time to let it grow. Another important 401(k) feature is the ability to borrow against vested assets. Some plans allow up to 50% of the account balance or $50,000 to be borrowed, which must be paid back within five years. If not, the remaining balance of the loan plus interest is regarded as a taxable withdrawal and can be subject to income tax and a 10% penalty if you quit your work before reaching 55.
What are the benefits of a 401k?
401(k)s offer several advantages for workers. They provide an easy way to save money through a convenient payroll deduction, and many employers provide matching contributions to encourage employees to save as much as possible. 401(k)s also allow employees to invest pre-tax dollars, which reduces their taxable income and potentially lowers the amount they pay in taxes at retirement.
Most 401(k)s offer various investment options, including index and active mutual funds; large-, mid-, and small-cap stocks; growth, value, and conservative investments; and company stock. Choosing the right mix of investment vehicles is critical to creating a portfolio that meets your unique financial goals and risk tolerance. Suppose you’re uncomfortable selecting investments for your 401(k) or need help building a long-term savings plan. In that case, you can ask your employer to provide a financial planner who can design a strategy that aligns with your goals. You can also find tools (online calculators, worksheets) to help you determine your risk tolerance and identify appropriate investment options.
Lastly, 401(k)s offer a tax break when you withdraw your money at retirement. But beware of starting too soon, resulting in income tax and a 10% penalty if you’re under age 55.
How do I get started with a 401k?
A lot of information and choices are coming at you when you first start thinking about saving for retirement. Even if you have the best intentions, it can be easy to get overwhelmed and not take the time to make informed decisions about your future. That’s why starting as soon as possible is important, and working with a financial planner to guide you through your options. One of the most important things to remember is always to contribute enough to take advantage of any company match your employer offers. You’re passing up free money if you don’t do it.
Also, remember to fill out a beneficiary form, which designates who gets your money if you die. You’d be surprised how many people need to remember to update this information after marriages, divorces, or children are born. Most 401(k)s are administered by a financial firm that will send you important documents and disclosures about your account. When you leave your employer, you can typically either roll over your account to your new company’s plan or move it to an IRA, where you can reap the benefits of tax deferral and higher interest rates.
