What is a 401(k)?A 401(k) is an employer-sponsored retirement plan with some up-front tax benefits. The money you contribute to a 401(k) is tax-deferred, so income you put toward your 401(k) is not taxed as income as long as it is within the contribution limits.
If your employer offers a plan, you typically sign up through the human resources (HR) department first. Then you determine a contribution amount from each paycheck which is then allocated to your chosen investments - employers typically offer a list of mutual funds from which to choose.
How it worksUnfortunately, understanding 401(k) plans and how they work can be somewhat of a mystery. You may be a diligent participant making regular contributions via payroll deductions, but what do you really know about what makes your 401(k) tick?
Sponsors and administratorsFirst of all, it's important to understand that your employer typically does not invest your money for you. However, your employer serves as your plan's sponsor. The role of the sponsor is to take your payroll deduction, deposit it into an account on your behalf, and then select another company (called the investment manager), to manage the plan and invest your money. If you're unsure about yours, just ask your company's HR or payroll representative. Your 401(k) account statement can also provide you with information on your plan's investment manager.
How your money is investedOnce your employer sends your deduction to the investment manager, it is invested. However, where it is invested is often up to you. Typically, most 401(k) plans will allow you to select from several different mutual funds in which to invest your money. Having a variety of options can be a good thing, but for some people, making the decision about where to put their hard-earned dollars can be a somewhat daunting task. After all, everyone wants to put their money where it will benefit them the most.
In many cases, investment managers will offer “groups” of mutual funds that are based on specific retirement goals and individual risk tolerance. This can make it a bit easier to decide where to direct your contributions.
For example, your plan's investment manager might offer a choice of funds for people who have long-range retirement goals and don't plan on retiring for another 30 plus years. Or, they might offer a group of funds for individuals who are less than 10 years away from retirement.
It is important to be proactive and learn as much as you can about the different types of funds that are offered in your plan. You can do this by taking advantage of employer-provided information and by asking questions. Most investment managers have interactive websites that you can use to not only review your 401(k) holdings, but to learn more about your investment choices.
The benefits of a 401(k)
There are plenty of benefits to having a 401(k), so much so that a recent survey showed that 89% of employees who are offered a 401(k) will participate in it. Here are just a few of the pluses:
- Employer match — Imagine getting free money from your company. That's essentially what an employer match is. Employers often make matching contributions for employees who contribute to the plan. For example, an employer might contribute 50 cents for each dollar that participating employees contribute up to a specified limit. Every little bit helps.
- Automatic contributions — When you have your funds taken out of your check automatically, you'll be more inclined to participate. On day one of your job, find out if you're enrolled automatically and how much of your base pay goes into the account (and raise it if you can). You'll be grateful tomorrow for what you put in today.
- Pre-tax contributions — A huge benefit of a pre-tax retirement savings account is that it can reduce your taxable income today, so you won't have to pay taxes until you withdraw your money in retirement.
- Retirement savings-boost — Many people think that Social Security will provide the bulk of their retirement funds. While Social Security will help, every little bit - including 401(k) investments - can help secure a comfortable life in retirement.
How much should you contribute?As of 2022, the 401(k) contribution limit is $20,500 a year, unless you're over age 50. Individuals age 50 and over are allowed to make an additional “catch-up” payment of $6,500 per year, bringing their annual max allowed contributions to $27,000. If you're in a position to invest the max into your 401(k), the tax breaks can make it extremely worthwhile.
If these amounts just aren't feasible, it's still important for you to start saving for retirement. For example, try starting off small and setting aside 5% of your monthly income into a savings account for several months, and then assess whether it affects your ability to meet your monthly obligations.
The fact is, how much you should be saving for retirement is an individual choice, as there are plenty of financial factors to consider. For example, do you have a large amount of credit card debt, student loans, or other financial obligations that you're trying to get under control? Do you have an emergency fund established?
Everyone's situation is unique and there isn't a one-size-fits-all approach as to how much you should be socking away into your 401(k). If you feel that you might need some help when it comes to retirement planning, then consider speaking with a qualified financial professional who can help.
Can I cash out my 401(k) before I retire?While it may be tempting to withdraw money from your 401(k), you may want to evaluate the situation closely before doing so.
If you withdraw money from your 401(k) retirement savings account before you reach age 59 ½, you'll be hit with a 10% early withdrawal penalty. In addition, you'll be required to pay regular income taxes on the withdrawal. Note: there are certain situations where the penalty may be waived.
Remember, the money in your 401k retirement savings is meant for your retirement. If you spend it now, you risk jeopardizing your financial security at a time when you need it the most.
If you need more information about planning for retirement or how a 401(k) works, visit the Protective Learning Center.