A 401(k) Can Help You Live Well in Retirement: Here Are the Details
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 options, 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 plan 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 make the most of the free money.
It’s up to you how much you want to put in, though there are contribution limits of $19K of your own money per year, as of 2019.
Once you turn 50 years old, you can make 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 put, it’s a section of tax code introduced in 1978 designed to make it easier for employers to help their workers get in good financial 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 way people save for retirement some 40 years later.
Advantages and Disadvantages of a 401(k)
As with most retirement or investment plans, a 401(k) has its pros and cons.
Pros of a 401(k)
Do you like free money? Then a 401(k) is fantastic. If your employer offers a 401(k) match, that’s an added benefit you need 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 make $40K per year and max out my employer match, I’ll get an extra $2,400 per year in my retirement savings plan.
A 401(k) is an easy way to save for retirement without realizing you’re doing it. The money 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 managers or financial advisers.
Cons of a 401(k)
A 401(k) typically has more limited investment options than other retirement accounts. This is not a big deal if, like me, you have no idea 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 prefer an account that gives you more freedom to invest your money 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 money 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 way, you’ll need to weigh the cost against the benefit before making the decision to use your 401(k) funds.
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?
Taxes for your 401(k) work in one of two ways. In a traditional 401(k), you make 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 make. 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, making it better to pay taxes on your 401(k) contribution now. However, it’s impossible to predict the future, so just 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 idea to speak with a financial 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 quit 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 quit or are fired, your money stays in the account.
My friend and ex-colleague, Timothy Moore, told me how he handled his 401(k) when he switched jobs.
“My new employer offered a 401(k) through Fidelity, so I just called them to hear what options 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 more investment choices, many people find it easier to consolidate their accounts by rolling over their old 401(k) funds into their new company’s 401(k), (assuming the new employer will accept the rollover). Age, investment goals 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 job until you reach this milestone if you want to keep the free money contributed by the company.
401(k) Investment Categories
A 401(k) helps build your retirement savings by investing 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.
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 allows investment in hundreds of bonds, which is less risky than investing in individual bonds.
Unlike stocks and bonds, annuities give out regular payments once you make an initial upfront investment.
The mix of 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 risk 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 freelancer or an independent contractor, you can still save for retirement. The most common way 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), limits how much you can save per year. As of 2019, the maximum contribution amount 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 money 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.