If you’re planning to retire someday and want to continue your current lifestyle — or something akin to it — you’ll need to start setting money aside. There are several ways you can save or invest, but the most basic plan could be right where you earn your paycheck. Some 56% of companies offer a 401(k), according to the U.S. Bureau of Labor Statistics. KSL Jobs explains what it is and how to get the most out of a 401(k).
What is a 401(k)?
In short, a 401(k) is an employer-sponsored retirement savings plan. Employees can contribute money by having funds automatically withdrawn from their paychecks. The money is taken out pretax, meaning you won’t need to pay taxes on the income that is invested until you later withdraw it.
Companies typically hire an outside administrator to oversee the plan. The contributions are put into mutual funds made up of money market investments, stock and bonds. Advisers are available to answer questions, make changes and manage paperwork.
Employers cannot require you to invest in a 401(k). However, since the Pension Protection Act was passed in 2006, companies may now automatically enroll new employees. If that’s the case, you will be given the chance to opt out, usually within a certain time period — one month, for example. Aside from your initial employment, there may be an annual sign-up period when you can start contributing, change the amount or cancel it altogether.
If you do choose to participate, your company may offer a 401(k) match. This is basically free cash from your employer. According to the U.S. Department of Labor Statistics, 41% of employers offering a 401(k) will match employee contributions — between 0 and 6%, the median being 3%.
How it works
As an example, say the company will match up to 4%. You earn $50,000 and choose to contribute 4%, or $2,000. Your company will then add another $2,000, thus doubling your investment amount. You can invest as much as you’d like — up to $20,500 per year for 2022 (or $27,000 if you’re over 50). But the company will only match up to the predetermined percentage. To get the most out of your 401(k), it makes sense to take full advantage of the employer match.
Before counting your chickens, so to speak, there is a caveat to matching funds. Companies may require a vesting period. You need to work a certain amount of time — often one to six years — before you can have that additional money.
Many businesses have a tiered payout schedule. For instance, you get 20% of the matched contribution amount per year for five years, when you are then fully vested. It’s a way employers encourage you to stick around longer. Of course, you always have access to your own contributions.
While you could withdraw the money you invested personally anytime, that doesn’t mean you should. A 401(k) is intended to be retirement savings, and you receive tax breaks for contributing to one (remember, investments are tax deferred). So, there is a hefty penalty if you withdraw that money early.
While it may be tempting to make an early withdrawal, it should only be used as a last resort. If you are under the age of 59½, you’ll most likely incur a penalty of 10% of the amount taken out. In addition, you’ll owe income tax on the amount withdrawn.
If you need the funds now, you may be able to take a loan out of your 401(k). You can repay it with deductions from your paycheck. Check with your financial adviser for details.
Any contributions you make into a 401(k) are yours. If you leave a company, you take your funds and any vested amount with you. The account can then be rolled over to a new one, either with your new employer or an individual retirement account.
In addition, if your employer goes out of business, your money is still safe. In this case, you can rollover the funds into an IRA.
Roth vs. traditional
Most companies offer a traditional 401(k) plan, but another type is becoming popular — a Roth account. The most notable difference with a Roth vs. traditional 401(k) is the way taxes are paid. With the traditional account, your contributions are taken out of your wages before taxes, thus making your taxable income lower. Once you take the funds (and any gains) back out, the withdrawals will be taxed as regular income.
With a Roth 401(k), your contributions are made with after-tax funds. That means you pay taxes on your full income today, including the money invested. But when it comes time to withdraw the funds, you won’t owe any more taxes. All the funds you withdraw, including gains, will be tax free in retirement. Employee matching contributions will still be taxable, however.
While you can start pulling out funds at the same age, there is one other difference. You must have the Roth 401(k) for at least five years, whereas there is no such rule for a traditional account.
If you want to diversify, you can contribute to both a Roth and traditional 401(k). But keep in mind, the contribution limit is a combined total.
Which is better?
If you have a choice, which would be better? That depends on you. If you are currently in a low tax bracket, but think you will be in a higher one once you retire, a Roth 401(k) makes sense. But if you are in a high tax bracket now, but will be a lower one in retirement, a traditional account might be better.
Enough is enough
What is the correct amount to invest? A 401(k) is for your retirement, so consider how much you’ll need to live comfortably. Chances are you’ll want to eat, live in a home and possibly go on a vacation once in a while. A general rule of thumb is to plan on living on 80% of your pre-retirement salary annually. Thus, if you currently earn $75,000 per year, plan on $60,000 per year to maintain the same standard of living.
Fidelity Investments recommends saving 15% of your income annually for retirement. The financial services firm suggests the amount you should ideally have saved based on age:
- Age 30: as much as your starting salary
- Age 40: three times your salary
- Age 50: six times your salary
- Age 60: eight times your salary
- Age 67: 10 times your salary
These are generic figures — you can always save more. Get the most of your 401(k) by investing as much as you reasonably can. No matter your age, simply increasing your contribution by 1 or 2% can make a significant difference.
Once you hit the age of 59½, you can withdraw — or, take a distribution — of any or all of your 401(k) fund without penalty. If it is a traditional account, any withdrawal will be taxed as regular income. If it’s a Roth, it will be tax free.
If your employer offers a 401(k), it can be a simple way to start saving for retirement. Plan advisers can help you sign up and answer any questions. If you can choose between a traditional vs. Roth account, decide if it would be more advantageous to pay taxes now or later. Finally, take advantage of any 401(k) match that’s offered by investing — at least — the maximum matching amount.
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