What’s a 401(k)?
One of the most popular ways to save for retirement is a 401(k) plan — and for good reason. It’s a simple way to save, and it’s frequently offered through employers as a benefit alongside salary, health insurance, and other perks. (Note: If you work at a nonprofit, educational institution, or other tax-exempt organization, you may be offered a 403(b). These are very similar, and in this article we’ll just use the term 401(k) to refer to both types of employer-sponsored retirement accounts.)
If you’re self-employed or don’t work for a company that has an employer-sponsored 401(k), you still have quite a few options when it comes to saving for retirement. But if your employer offers a 401(k) plan, use it. Here’s some valuable information to get you started.
Do I Really Need One?
Social Security may not provide enough income for the vast majority of people to live on in retirement. Starting a retirement account in your twenties or early thirties and contributing regularly can be the key to achieving a comfortable and independent retirement. Not convinced? Look at what happens if you don’t contribute to one.
As a hypothetical, let’s say you are 25 years old, make $45,000, and have no money saved in a 401(k). Perhaps you start contributing 5 percent of your salary and get a dollar-for-dollar match from your employer, along with an annual raise of 3 percent. Now let’s assume a 7 percent annual return on the investments within your 401(k) and a plan to retire at age 65. With these variables in place, you will have an estimated $1,367,094 at retirement.
On the other hand, if you start saving just five years later, at 30, you will have just $917,750 at retirement. That’s a difference of almost $500,000. It’s nothing to sneeze at.
(Of course, actual returns can be higher or lower, and there is no assurance any particular rate will be achieved. Variations in returns, contributions, withdrawals, and other factors will affect your total earnings.)
The bottom line is if you wait to start saving for retirement later in life, you’ll probably need to contribute a larger percentage of your income to reach your goals.
What’s Special About 401(k)s?
There are some major benefits that come with 401(k) retirement plans, including:
Many employers motivate their employees to save for retirement by offering matching contributions. This is where the employer matches a certain percentage of the money you contribute to the 401(k), up to a set maximum. For example, if an employer offers a dollar-for-dollar match on up to 5 percent of salary, and you contribute 5 percent, a total of 10 percent is added to the account with the matching contribution. This is free money, so make sure you are contributing enough to maximize your employer match. However, note that sometimes employer-funded retirement accounts have “vesting” periods, so you may not actually be entitled to the full match until you’ve been at your company for a certain amount of time.
Compound returns means that the money you invest earns a return, but that return is reinvested and also earns more money. Over time, this can have a very powerful impact on your retirement account. For example, your balance could double almost four times over 40 years if it earns a 7 percent annual compound return. (Again, these aren’t guaranteed returns, but give you an idea of how to think through your options.)
Since your taxes are based on your income after you contribute to a traditional 401(k), your taxable income decreases based on the amount of contributions you make to the plan each year, which can potentially put you into a lower tax bracket — and you don’t pay any taxes on the growth or earnings within your plan until you withdraw the money during retirement.
Most of the investment options offered in a 401(k) plan have lower fees compared to those you could buy outside your employer-sponsored 401(k) plan. On top of that, more employers are offering extremely low-cost index funds that can save you even more money by avoiding the higher fees that mutual funds usually charge to manage investments.
You also may be able to take a loan out on your own 401(k) plan, which is something you can’t do with an IRA. Depending upon the employer’s plan, you can access up to 50 percent of the vested balance, up to a maximum of $50,000. Usually the loan has a five-year term, and you must pay yourself back with interest. Some people use it to purchase a home, in which case the loan term can extend to approximately 10 years. Every plan is different, however, so check with your employer. Finally, remember that, if you don’t pay these loans back, it can impede your progress toward your retirement goals.
How Can I Get a 401(k)?
When you enroll in a 401(k), most employers will ask you to select a dollar amount or a percentage of your salary to contribute each pay period. Pro tip: Select the percentage option so your contributions will automatically increase when you get a raise. Most of the time, employers automatically deduct money from employees’ paychecks each time they get paid to be deposited into your 401(k), so you won’t even notice it’s gone. This amount changes each year, but in 2016 the 401(k) contribution limit is $18,000 ($24,000 if you’re age 50 or older).
If you work at a company with a 401(k) plan, HR will likely send you some information about it when you become eligible to contribute. You may have the option to select from two types: a traditional 401(k) or a Roth 401(k). While you deposit money into a traditional 401(k) with pre-tax money, a Roth 401(k) allows you to contribute money on an after-tax basis.
When money is withdrawn in retirement, traditional 401(k) withdrawals are considered taxable income, while Roth 401(k) withdrawals are tax-free qualified distributions as long as the account has been open five years and you are older than 59.5, disabled when you take the money out, or the distributions are going to your heirs upon your death.
There are calculators that can help you determine what type of 401(k) is right for you based on these variables. Generally speaking, however, Roth 401(k)s are more valuable when you are younger and not as concerned about tax deductions.
How Much Should I Contribute?
Ultimately, the percentage you decide to contribute depends on the lifestyle you want to have when you retire. Some people are willing to work hard and sacrifice fun experiences now in order to max out their 401(k)s and possibly have the ability to retire a little earlier. But for some people it’s not worth the sacrifice.
Once you have an idea of how much money you want to have when you retire, you can use a retirement calculator to determine how much you should be saving each month to reach your goals. Again, it’s always smart to start sooner rather than later. For every year you delay contributing to a retirement plan, you may need to contribute a higher percentage from the start.
What Happens When I Leave My Job?
If you do decide to leave your company (or have already done so), you have a few options:
Cash It Out
While it’s certainly an option to cash out your retirement account when you leave a company, it is not a course of action most financial planners would recommend. If you do, you may owe both federal and state taxes, as well as a 10 percent penalty (unless you are at least age 59.5) on the money in the account.
You can leave the money in your old company’s 401(k), although you should note that some plans require a minimum amount to keep the money there. Leaving it makes sense if you like the options in that plan (like how your money is being invested, for example).
Move to an IRA
The major benefit of moving your funds to an IRA is that you would have a lot more investment options. You could potentially select investments from a much broader list of mutual or index funds, ETFs, stocks, or bonds. However, keep in mind that most 401(k) plans offer low-cost investments like index funds among their options.
Roll It Over
If you jump to a new employer, you can also take your 401(k) money and move it into their plan if they offer that option. This keeps everything consolidated and simplifies management.
Erik Almon began his planning career as a Financial Advisor at Morgan Stanley in 2004. He’s been a Certified Financial Planner™ since 2008 and earned his MBA in 2011. Before joining Society of Grownups, Erik ran his own personal financial planning practice for several years.
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