Everything You Need to Know About 401ks
You’ve probably heard of a 401k. You’ve probably heard that it is a good thing because it really is. A 401k is a great way to save money for retirement. There are other ways to save for retirement, including IRAs, life insurance policies, and even day-trading, but all we’re going to talk about in this article is the 401k. This will not be comparing different investing or retirement options, just giving you all the information you need to know about the 401k. We’re going to talk about the advantages of the 401k, the disadvantages of it, and some instructions on how to use it.
Advantages of the 401k
There are quite a few. However, the two most powerful advantages are that contributions to your 401k come out pre-tax and (usually) with an employer match. What does it mean that contributions to your 401k come out pre-tax? In other words, your employer takes out whatever percentage you are contributing to your 401k before tax is calculated on your income. This is actually a huge benefit. Why? Because then your taxes are calculated on a smaller income than otherwise, so if you normally make $2,000 per month pre-tax, and have $1,700 post-tax, and you start contributing $200 per month into your 401k, that means your taxes are calculated off of $1,800 instead of $2,000. So instead of having $200 less each month, because of the discount on taxes, you’ll only have about $150 less each month. You can learn more about this particular feature here.
The next big advantage of the 401k is the employer contribution. This is literally free money. Most employers will offer up to a 3% match when you contribute to your 401k. Some employers require you to contribute more if you want the full match (you may have to contribute 5% for them to contribute 3%), but this is almost always worth it. The employer contribution is one of the things that makes the 401k such a great option because the value of your investment goes higher than your contribution automatically when you contribute to it.
Disadvantages of the 401k
The biggest disadvantage of the 401k is that you can’t touch it without a penalty until you’re 60 years old (technically 59.5 years old). This is because the 401k is intended as a retirement vehicle, and having this restriction helps prevent tax fraud. There are also limits to how much you can contribute to your 401k annually. Your contributions are limited to $15,000 per year by the IRS, and your employer may restrict your contributions further. What can be seen as either an advantage or disadvantage depending on your situation, is that you have to choose where your funds are invested. Usually, your employer will provide a pamphlet or booklet that explains your investing options and instructions on how to make your selection. There should also be a risk guide that tells you how risky each of the options are. With more risk comes greater potential returns.
How it Works
First, you need to find out if your employer offers a 401k at all, and if they offer a match. This should have been covered in the onboarding process when you were hired, but in case you can’t remember, weren’t paying attention, or it wasn’t covered for some reason, you can start by talking to your HR manager or immediate supervisor. Your employer may want you to wait until the open enrollment period to make your selections for the following year, so you may have to sit on your hands for a bit before you can start contributing a portion of your income. If that’s the case, take advantage of the time to learn more about investing and your different options your 401k has. You may also want to practice living with less money from each paycheck.
If you change employers, you can either keep your 401k with your current employer (but it will no longer be contributed to and will just grow based off of its current size) or you can transfer it to your new employer if they have a 401k program. You will probably have to re-select an investing option to use when you make the switch. Your money comes out of your check automatically before you ever see it, so it’s a fairly painless way to invest for your retirement. Investing for your retirement is extremely important, and the younger you are when you start, the better off you will be when the time comes. Don’t be afraid to seek advice if you have questions about what options suit you the best.