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A 401(k) Can Help You Live Well in Retirement: Here Are the Details

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Even if you’re young, it’s never too early to think about retirement. If you have a full-time job that offers a 401( k) savings plan, you might already be saving for your future. But if you’re not familiar with your alternatives, it’s important to know what a 401( k) is, how they work and how you can get one.

What is a 401( k) and How Does it Work?

A 401( k) is an employer-sponsored investment scheme designed to give you a tax break on your retirement funds. Many employers will match your contributions up to a certain percentage.

The idea is that you, the employee, allot a certain amount of your paycheck to go straight into your 401( k ). You can either do this pre- or post-tax. If your employer offers a matching contribution, you should build the most of the free money.

It’s up to you how much you want to put in, although there was contribution limits of $19 K of your own fund per year, as of 2019.

Once you turn 50 years old, you are able to build catch-up contributions to your 401( k ). These can total up to $6,000 per year. Catch-up contributions allow you to build your 401( k) even more before you retire.

What Does 401( k) Stand For?

The name 401( k) has a fairly dull origin with no hidden meanings. Simply set, it’s a section of tax code integrated within 1978 designed to make it easier for employers to help their workers get in good fiscal shape for their retirement years.

Interestingly, the man behind the 401( k ), Ted Benna, told Workforce he had no clue that it would become the main route people save for retirement some 40 years later.

Advantages and Disadvantages of a 401( k)

As with most retirement or investment schemes, a 401( k) has its pros and cons.

Pros of a 401( k) Free Money

Do you like free money? Then a 401( k) is fantastic. If your employer offers a 401( k) match, that’s an added benefit “youre going to” take advantage of if you want to get the most out of your compensation package.

As an example, my employer offers to match 100% of my 401( k) contributions up to 6% of my income. If I stimulate $40 K per year and max out my employer match, I’ll get an extra $2,400 per year in my retirement savings plan.

It’s Easy

A 401( k) is an easy way to save for retirement without realise you’re doing it. The fund automatically comes out of each paycheck, so if you sign up as soon as you start a new job, you won’t miss the money.

Since your employer is your 401( k) plan sponsor, the fees are usually less than if you set up a retirement account on your own. As with group rates on health insurance, your company can negotiate fees for things like mutual fund directors or fiscal advisers.

Cons of a 401( k) Limited Options

A 401( k) typically has more limited investment alternatives than other retirement account. This is not a big deal if, like me, you have no notion how or where to invest your money and need an expert to do it for you. But if you’re really into playing the stock market, you might opt an account that gives you more freedom to expend your fund outside of stocks, bonds and cash.

Early Withdrawal Penalties

Another 401( k) disadvantage is early withdrawal penalties. Most regular savings accounts allow you to withdraw fund when you need it. But if you borrow money from your 401( k) before age 59 1/2, you’ll have to pay a penalty of 10%.

There are many reasons you might need to borrow from your 401( k ). Perhaps you need a down payment on a house, or maybe you need some extra cash during a period of unemployment. Either route, you’ll need to weigh the cost against the benefit before create the decision to use your 401( k) funds.

Vesting

You might come across the term “vesting” when signing up for your 401( k ). This refers to how long you need to work for your company before you own all the funds in the account. My company’s vesting schedule is two years, so if I quit before that I would forfeit the employer-contributed funds in the account( though any contributions I made would remain mine ). That’s an incentive to stick around for at least two years.

How Do 401( k) Taxes Work? Tax return and 401k paperwork.

Taxes for your 401( k) work in one of two ways. In a traditional 401( k ), you attain pretax contributions. With this type of account, you’ll pay taxes when you withdraw the funds after retirement.

Another option is a Roth 401( k ), which approaches taxes slightly differently.

What is a Roth 401( k )?

Your employer might offer the option of a Roth 401( k ), which taxes contributions you build. That means you can withdraw the money tax-free upon retirement.

Traditional or Roth?

Before deciding between a traditional and a Roth 401( k ), consider your current tax bracket and the one you expect to be in upon retirement.

Most people will be in a lower tax bracket when they retire because their monthly retirement income will be less than their salary while working. In this case, you might choose to stick with a traditional 401( k ).

You’ll also need to consider what the tax code might look like when you retire; the tax rate may well be higher, constructing it better to pay taxes on your 401( k) contribution now. However, it’s impossible to predict the future, so simply use your best judgment.

You might have the option to invest part of your money in a traditional 401( k) and part in a Roth 401( k ). Check with your employer to see if this is possible.

Ultimately, the decision is yours, though it’s a good notion to speak with a fiscal adviser to determine what’s right for you.

What Happens to Your 401( k) When You Quit?

Since a 401( k) is an employer-based retirement plan, you’re probably wondering what happens to the money if and when you cease your job.

While your employer sponsors your account, it doesn’t own it. You own the account, and it’s stored by a brokerage firm. If you cease or are fired, your fund stays in the account.

My friend and ex-colleague, Timothy Moore, told me how he managed his 401( k) when he switched tasks.

“My new employer offered a 401( k) through Fidelity, so I simply called them to hear what alternatives they offered, ” he said. “Instead of adding the money I had earned in my existing 401( k) to my new 401( k ), I decided it was time to open an IRA and regularly contribute on my own.”

Although IRAs offer greater investment choices, many people find it easier to consolidate their accounts by rolling over their old 401( k) monies into their new company’s 401( k ),( assuming the new employer will accept the rollover ). Age, investment aims and how actively employees want to manage their savings can influence their decision.

“For many people, having everything automated through their employer’s 401( k) plan is the only reason they have the discipline to save every month, ” said Paul Ruedi Jr ., a certified financial planner in Plano, Texas, who specializes in retirement planning.

Remember, though, that many employers have a vesting period. Try to stick out your work until you reach this milestone if you want to keep the free fund contributed by the company.

401(k) Investment Categories Stock market numbers are displayed on a computer screen

A 401( k) helps construct your retirement savings by expending your money. You can choose to have complete control over where your money is invested or pick general categories and leave the decisions up to your broker.

According to the Financial Industry Regulatory Authority, most 401( k) plans have four main investment categories.

Stocks

Your company’s 401( k) may allow you to invest in stocks. If this option is available, you’ll likely be able to purchase only company stock. Individual stocks may be an option if your plan has a broker.

Stock Mutual Funds

A stock mutual fund allows you to invest in hundreds of stocks rather than individual stocks for a more diverse portfolio with less risk.

Bond Mutual Funds

Similar to a stock mutual fund, a bond mutual fund lets investment in hundreds of bonds, which is less risky than investing in individual bonds.

Variable Annuities

Unlike stocks and bonds, annuities give out regular payments once you make an initial upfront investment.

The mix of such investments you choose for your 401( k) is up to you, but you should take a few things into account, including your age. The younger you are, the more hazard you can afford to take with your investments. But if you’re nearing retirement age, riskier investments could result in you losing the money you need to live on. Stocks are riskier than bonds, so your 401( k) will likely be heavier with stock investments when you’re younger and switch over to higher bond investment as you get closer to retirement.

What if I Can’t Get a 401( k )?

A 401( k) is a great benefit, but not everyone is eligible. If your company doesn’t offer one, or if you’re a freelance or an independent contractor, you are able to save for retirement. The most common style is via an individual retirement account or IRA.

Like 401( k) plans, you can get a traditional IRA or a Roth IRA. An IRA, like a 401( k ), restriction how much you can save per year. As of 2019, the maximum contribution sum is $6,000. People 50 or older can contribute an additional $1,000.

Even if you have an employer-sponsored 401( k ), you should still consider signing up for an IRA to supplement your retirement. I chose to max out my employer match in my traditional 401( k) and open a Roth IRA to make the most of my retirement savings.

Is a 401( k) a Good Idea?

A 401( k) is an ideal first step to saving for retirement. If your employer offers a 401( k ), look into maxing out the amount it will match, and consider either adding more fund each month or opening an IRA in addition to your 401( k ).

Catherine Hiles is a mother of two trying to balance retirement investment with child care costs and regular savings. She currently has a traditional 401( k ), a Roth IRA and a sizable monthly day care payment.

The Penny Hoarder Editor Susan Jacobson contributed to this report.

This was originally published on The Penny Hoarder, which helps millions of readers worldwide earn and save money by sharing unique job opportunities, personal stories, freebies and more. The Inc. 5000 ranked The Penny Hoarder as the fastest-growing private media company in the U.S. in 2017.

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