If you’re just joining the workplace, you may feel overwhelmed with all the financial information you’ve been presented with and all the decisions you’ve had to make. But while you may still be hemming and hawing between HMOs and PPOs as you examine your health plan options, this is an obvious decision to make. Say yes to any company 401(k) plan. Here’s what it is and why it’s one of the most effective options out there for saving for retirement.
What is a 401(k)?
A 401(k) is a retirement plan which allows workers to set aside money directly from their paycheck into an account where it is invested for the long term. A traditional 401(k) account uses dollars “before taxes”, so you are not paying your normal tax rate on the money you set aside. The money grows tax-free until you withdraw it in retirement (at which point, the thinking goes, you’ll likely be in a lower tax bracket). Some employers also offer a Roth 401(k), which is funded with after-tax dollars. Even though you make contributions with money that has already been taxed, withdrawals you make in retirement will be tax-free.
Additionally, many employers offer a “compensation option” to encourage participation; In other words, they’ll match a percentage of the contributions you make, further bolstering your account at no cost to you.
Well… that’s the short version, but we hope you’ll dive into it to learn more about this fantastic savings option.
Why is it called a 401(k)?
Most financial vehicles have pretty boring names, right? The 401(k) plan is no exception, and like many of these vague names, it comes from the part of the IRS tax code that gave it its name when it was introduced in 1978.
Tell me more about what makes it so special.
As mentioned, you won’t pay any taxes on the money you put into the 401(k) plan. Many employers also offer a matching contribution, and you won’t have to pay taxes on the matching funds either. A common matching percentage is for your company to put in 0.50 for every $1 you contribute up to 6% of your income (although they can also give more, up to the limits mentioned below). In that case, you are actually saving 9% because the employer is contributing that extra 3%.
In addition, you do not have to pay taxes, since the money accumulates thanks to the growth of the stock market and the interest on investments.
Of course, we all know that there are only two certain things in life, and one of them is taxes. In the end, you will pay taxes on the money at the time you withdraw it, but at the tax rate in effect at that time. And since you don’t start withdrawing until age 59 ½ or older, the tax rate may be lower.
The second part of the 401(k) magic comes from “compound interest.” You can read all about how compounding works here; But generally what it means is that as your investments generate interest earnings, you will earn interest on top of that interest. So, with each cycle, your account continues to grow exponentially as you earn interest on the interest, again tax-free.
It’s hard to describe what a big deal this is. But we’ll try… here’s an amazing chart that shows how investing early and taking advantage of compound growth can help you end up with a lot more in your retirement fund than someone who started just 10 years later, but contributed much more in total .
Or, for another classic example, guess this: Would you rather have a million dollars or a penny that doubles daily for 30 days? (Tip: Go for the penny as it converts to $5 million. Yes, check it out).
How much can I contribute to my 401(k)?
This 401(k) account may sound incredible, and if you’re a super saver, you may decide to defer as much compensation as you can to actually build that account. But there are limits on the amount you can contribute each year. Federal rules dictate maximum annual contribution limits: For 2020, employees under age 50 can contribute up to $19,500, while those over age 50 can contribute an additional $6,500 (considered an additional “catch-up” contribution for help those who started saving late).
Annual limits apply even if you have more than one 401(k) plan; for example, if you started one at a previous job, then left the job during the year and started a new one at your current job.
Some companies may also have their own rules, and there is another aspect that may limit your contributions. The IRS places some additional limits on “highly compensated employees.” HCEs are those who earned more than $120,000 in the previous year (as of 2018) or owned more than a 5 percent stake in the company. Some companies may add another layer, designating someone as an HCE if they were in the top 20 percent of employees based on compensation classification. These HCEs can only participate fully based on the participation of non-HCEs: there is a formula that is based on the number of non-HCEs that participate or the amount they contribute. This is because the IRS wants to ensure that 401(k) plans are not just a haven for the wealthy and that employees at all levels can participate.
If you’re able to save more than what’s allowed in your 401(k), you can look into other retirement savings options, such as a traditional IRA or a Roth IRA.
When do I receive the money?
So here’s the deal… when you commit to a 401(k), you’re essentially saying you’re putting the money away until you turn 59 and a half. That’s the earliest you can withdraw money without incurring penalties, and then you must start taking mandatory withdrawals at age 72. (this calculator will show you how much to withdraw). Remember that you will pay taxes at your then-current rate, which ideally is lower than your current rate.
If you try to withdraw the money early, not only will you be hit with a 10 percent penalty on any money you withdraw before that magical age of 59½, but you’ll also pay regular income taxes on the money you withdraw. which can be a big bite. So remember that putting money into a 401(k) is different than a savings account in that sense, but when you retire, you’ll be glad you stuck it out.
You also can’t liquidate your 401(k) just because you’ve left for a new job. In that situation, You have a few options regarding what to do with the account: Generally, you are allowed to leave the 401(k) where it is with your previous employer, or you can “roll it over” to your new employee’s plan or IRA.
In some cases, you may not be able to take full advantage if you leave your job; some plans require that you “award”, which means your employer wants you to stay a certain number of years before they take the money and leave. For example, if your company has a four-year vesting schedule, then you receive 25 percent of the employer match after the first year; then 50 percent after two; 75 percent after three; and on your four-year anniversary, all of the employer’s contribution is yours.
Where do I sign?
We thought you’d never ask. If you are not currently contributing to a 401(k), contact your human resources department as soon as possible. Some companies automatically enroll you, but if not, they can help you set up your paycheck so that a certain amount, whether a specific dollar figure or a percentage of your salary, is diverted to your 401(k). If you’re automatically enrolled, you’ll probably want to increase your percentage. Since the money comes out of your paycheck before you even see it, you won’t be tempted to reallocate the money to your vacation or shoe fund.
Human Resources will allow you to know who are the «administrators» of your company, that is, the people who actually invest the money for you. Your 401(k) doesn’t just fit into a big pool; You will need to choose which funds to invest in, among the various options offered by your 401(k) manager.
Ask as many questions as you need to ensure you designate a fund that is a good fit for your financial goals and risk appetite. For example, some are designed to be more aggressive, where the fund manager typically invests more in stocks, which could have more risk, but potentially more reward. Other funds are more weighted toward bonds, which are more stable and less likely to have large fluctuations, but which tend to have smaller returns. Your manager can walk you through your options and show you how to choose one, as well as how to monitor it and potentially move funds if necessary. And don’t forget to look at the rates, ideally they should be less than 1 percent.
Then, remember to keep increasing your savings as your salary increases. Small amounts can end up making a big difference throughout your life.
You may feel like you can’t afford to save, but the truth is, you can’t afford not to save… especially if your employer offers you a match; At the very least, you want to contribute at least that much. A 401(k) may sound too good to be true, offering tax relief and tax-deferred compounding and often even free money in the form of a company match, but it’s not.
It’s never too late, and certainly never too early, to think about your financial future. Starting to fund your 401(k) may be the secret to a happy retirement.
This information provided for informational purposes only; It is not intended to be used as accounting, legal or tax advice. Regarding these issues, speak with your accountant, tax or legal advisor.
Investing involves risk that includes loss of capital. This guide contains the current opinions of the author, but not necessarily those of Gigonway. These opinions are subject to change without prior notice. This guide has been distributed for educational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information contained in this guide has been obtained from sources considered reliable, but is not guaranteed. Gigonway does not provide legal or tax advice. Please consult your tax and/or legal advisor for specific tax or legal questions and concerns.