401(k) plans are one of the most common retirement savings vehicles used by Americans today. However, despite their popularity, 401(k) plans aren’t always well-understood, even by the people who participate in them. To help make sure you’re making the most of this powerful retirement savings tool, read on for a helpful guide to what 401(k) plans are and how they work.
What is a 401(k)?
A 401(k) is a type of retirement plan that is sponsored by your employer. The goal of the plan is to help you save for your retirement on a tax-deferred basis. When you participate in a 401(k), you can choose to contribute some of your paycheck to your 401(k) instead of taking it right away as cash. This allows that money to grow on a tax-advantaged basis and make the most of long-term compound investment gains. Your employer can also make contributions to your 401(k) on your behalf. A 401(k) is known as a defined-contribution plan, which means that your balance is determined by the contributions you make to the plan over the years and by how the plan investments have performed.
What are the benefits of participating in a 401(k)?
It’s not surprising that 401(k) plans are such a popular retirement savings tool when you consider the many benefits they offer. These include:
An automatic way to save—It can be difficult to find enough “leftover” money each month to put away for your retirement. But choosing to defer some of your paycheck and put it in your 401(k) allows you to “set it and forget it” when it comes to saving. The decision to save is already made for you, and your savings automatically grow without you having to take any further action.
Compound growth—The magic of compound growth can turn a little money into a lot, and a 401(k) is one of the best ways to take advantage of this. For example, if you contribute $5,000 annually to an investment account over a period of 30 years (that’s a total of $150,000), and if it’s assumed that your investments earn the historical average rate of return for the stock market, this means that at the end of the 30-year period, your account would be worth close to $750,000.
Tax advantages—Not everyone is aware that you get an upfront tax break when you contribute to your 401(k) plan. Every dollar you put into your 401(k) is a pre-tax dollar, which means that your current-year tax liability is reduced by the total amount of your contribution. This allows you to save for the future while also benefiting in the present.
Employer contributions—While employers are not required to make contributions to a 401(k), many employers do choose to match their employees’ contributions up to a certain percentage of their salary. Essentially, employer contributions are free, additional money toward your retirement.
How much should you contribute to a 401(k)?
The question of how much money you should be putting into your 401(k) will depend on your personal circumstances, but most experts recommend that at a minimum you contribute enough to ensure that you’re taking full advantage of your employer’s matching contributions. (If you’re not maxing out your employer’s contributions, it’s the same as if you were turning down free money.) Beyond this, it can be a good idea to consult with a financial advisor about how much you can and should contribute. Remember, thanks to compound interest, even a small increase in your contributions now can make a big difference down the road.
How should the money in your 401(k) be invested?
Most 401(k) plans will offer a variety of mutual funds and will give you the option of investing in some or all of these. Some mutual funds are stock-based, or equity mutual funds; others, known as fixed-income securities, invest in bonds; and some will be cash-based or money market fund options. Each of these fund categories contains its own set of sub-categories. Before making your investment decision, you’ll want to be sure you understand the different goals and risk levels so that you can choose the funds that are right for you. Also, don’t forget that diversification is an important element of your 401(k)—you’ll want to make sure you have a balanced portfolio with appropriate asset allocation.
When can you have access to the money in your 401(k)?
In general, anyone can withdraw money without penalty from a 401(k) as soon as they reach the age of 59 ½. Under some circumstances, you may be eligible to withdraw money from your 401(k) earlier (for example, in order to cover unreimbursed medical expenses or if you no longer work for the employer who originally sponsored your plan). If these exceptional circumstances don’t apply to you, you can still take money out of your 401(k) before you reach the standard age, but you’ll need to pay a 10 percent withdrawal penalty to the IRS.