Juggling families, careers, friends, and side hustles is no easy feat. As we navigate our busy lives, it’s only natural to focus on short-term obligations…which means retirement is probably not top of mind. But if we start saving now, we can position ourselves to reach that aspirational lifestyle sooner rather than later. Enter the 401(k)—a plan that makes it easy and tax-efficient to build our nest eggs for retirement. Most of us don’t take full advantage of the benefits of a 401(k), simply because we don’t understand how it works. Let’s change that! Keep scrolling for all the ins and outs you need to know.
Saving into a 401(k) is simple.
A 401(k) is the most popular employer-sponsored retirement plan. Unlike some other accounts that you can open on your own, you can only contribute to a 401(k) if your employer offers it in your benefits package. Once your account is set up, funding it is straightforward and low maintenance. First, you decide how much you want to contribute per year. If you’re unsure what you can afford to save, this personal budget will guide you. Next, your employer deducts a portion of your paycheck each month and funds your 401(k) directly. This is the ultimate way to save without thinking about it!
You’ll benefit from tax breaks.
Perhaps the most important thing to understand about a 401(k) is that it entitles you to tax deductions. Let’s say you earn $5,000 per month in salary and contribute $500 of it to your 401(k). In that case, you would only owe taxes on $4,500 that month. So not only do you tuck away some cash and allow it to compound with time, but you also reduce your taxable income. Plus, if you believe your tax rate in retirement will be lower than your tax rate today, it makes even more sense to defer these payments.
Your employer may match your contributions.
Saving for retirement may feel daunting, but you’re not on your own. Most employers will support you by matching your 401(k) contributions up to a certain percentage of your salary—often 3-6%. But there’s a catch. Your employer will only match what you actually contribute. That means you’re leaving money on the table if your company matches 5% but you only contribute 3%. You work hard to advance your career, and this matching benefit is part of your well-deserved compensation package. Take advantage!
You can choose your own investments.
What do you do with the money sitting in your 401(k)? Many people get confused and believe that the 401(k) itself is the investment. In reality, a 401(k) is a basket that holds your investments. Each plan offers a different menu of investment options, and you choose where to allocate your funds. Your age and risk profile should impact the ratio of your investments in riskier assets (like stocks) and safer assets (like bonds). As a young person, you have time to withstand fluctuation in the market and take a riskier approach. As you get closer to retirement, you’ll want to shift some of those riskier assets into safer bets that aren’t affected by market volatility. Many 401(k) plans offer target date funds that automatically evolve their investment mix as you age. This is an easy way to passively invest your 401(k), but beware of high fees!
If you switch jobs, no problem.
A new job is an exciting opportunity to start fresh. You know the drill—you enter a new lobby, brew new coffee, greet new coworkers, and open a new retirement plan. If you have a 401(k) from a former employer, there are a few options. You can leave your old 401(k) right where it is, transfer it to your new 401(k), or roll it into an IRA. You can also choose to cash out early. I hesitate to even include this option because it should be your last resort! You’ll pay ordinary income taxes plus a 10% penalty. For the full scoop, here are all the pros and cons to these 401(k) options.
A 401(k) carries some restrictions.
As with all good things, a 401(k) does come with some restrictions. For one, the federal government limits the amount you can contribute in any given year. Which makes sense if you think about it. For every dollar you contribute, that’s tax money the government has to wait years to receive. For 2017, the limit is $18,000, but it can change each year.
A 401(k) also restricts when you can withdraw your savings. Except for a few special cases, you can’t access your funds until you reach 59 ½ without incurring penalties. Because of this restriction, it’s important to find the right balance between your retirement savings and an emergency fund you can access today.
The bottom line is that managing your 401(k) in the right way can help you reach your retirement goals faster than you thought possible. A basic understanding of how it works is all you need to make the best decisions for your future.