When you open up a 401(k) account, you are one of the millions of Americans who is actively saving money for retirement.
The 401(k) plan is an employer-sponsored retirement savings plan. When you sign up for this plan, your employer distributes company stock to you, which also allows you to receive tax breaks and other benefits. Depending on the 401(k) you have, you may also receive benefits such as employer-matched contributions.
If your company offers a 401(k) retirement plan, you should consider opening an account.
When setting up a retirement account, you should know that the earlier that you start a 401(k) plan, the more money you will have come retirement.
However, before you begin aggressively saving money in your account, you must know how plans work and how you can benefit from them. You will also need to learn about the potential risks that they involve and how to best utilize your 401(k) plan to maximize your potential savings.
What is a 401(k) Plan?
When you have a 401(k) retirement plan, a percentage of your pay from a participating company moves into a retirement account.
It is a voluntary arrangement, and often the funds are transferred before they are taxed, which allows you to receive a tax benefit. A tax benefit is just one of many benefits of having a 401(k) retirement plan.
However, it is also important to understand that 401(k) plans cannot be withdrawn without penalty before a certain period that is relative to your age. Should you need to withdraw funds early, a fee will be deducted from your available funds for the early withdrawal.
What are the benefits of a 401(k) plan?
The primary benefit of a 401(k) plan is having a lower taxable income, pre-tax dollar contribution, company contribution match, and lifetime contributions. Let’s take a closer look at each:
Lower taxable income: When you have a 401(k) plan, the funds that you contribute into your retirement account is deducted from your taxable income. Meaning, that when tax season rolls around, that you will have a lower taxable income since you will pay less in taxes each year.
With this retirement plan, you are not only preparing for your retirement, but you are also receiving a significant tax break.
Pre-tax dollar contribution: Typically, the funds that you move to your 401(k) is sent before taxes are deducted, which means that the money you pay is considered pre-taxed. Since the portion that you transfer to your retirement account is not taxed, you end up paying less money to taxes.
Meaning, that if you contribute five percent of your earnings into your 401(k) account, you will only pay taxes on the 95 percent of the money that you do not have in your retirement account since the five percent in your retirement account is not taxed.
When you contribute money to your 401(k), the tax break that you receive may make up the amount of money that you add. For example, if you increase your contributions by one percent, the chances are high that you will not notice the change in your paycheck since fewer taxes are withheld.
However, it is essential that you know that you will need to pay taxes eventually. Usually, this occurs when you retire and start withdrawing funds from your retirement account.
Company contribution match: When you open a 401(k) plan, your employer will match what you contribute. Depending on the plan, an employer may contribute a specific amount of money to your 401(k) based on the amount that you contribute.
While it is common for employers to match 50 percent or less of your contribution, some may even match dollar to dollar. However, you should know that some may not match your contributions at all. Also, employer contribution limits may change each year, which means, that there may be stipulations where your employer will only contribute after you are fully vested.
When you are “fully vested,” you have met specific requirements, such as working for a company for a certain amount of time, and you are now eligible for your employer to match your contributions.
Lifetime contributions: Depending on the retirement plan you have, you may need to stop contributing to your plan once you reach 70 and a half years of age, even if you are still working. Also, some distributions or withdrawals may need to be taken out of your account.
However, when you have a 401(k) plan, you can continue to contribute to your retirement account no matter your age, as long as you are still working. You also do not need to take required minimum distributions (RMDs) from the account. With a 401(k) plan, you will benefit greatly in the long run.
Infographic: Understanding Retirement Plans
What are the risks of having a 401(k) plan?
Since payouts for 401(k) plans depend on investment performance, there are a few risks you must know about. When you take part in any retirement opportunity, there is always a chance that you will lose a portion of your funds. Some assets carry more risk than others, like making international investments.
Since you can choose the assets in your portfolio, the level of risk you take is up to you. However, you can also reach out to a professional to manage your retirement account. If you prefer to manage your own retirement account, you will need to take into account the level of risk you are willing to take.
Doing so will affect how soon you can retire and how much income you contribute.
Where there are risks to retirement accounts, there is also a chance that you will gain money on your investments.
Although it is essential to know about the risks, you should know that many can be minimized if you plan accordingly. One such way is to diversify your portfolio by ensuring that you have a variety of different asset types, such as bonds and stocks.
Tips for your 401(k) plan
There are many different 401(k) plans with various regulations, which means that you must know what your plan consists of.
Having a 401(k) retirement plan is a serious commitment. However, when you are knowledgeable about your plan, and you take the time to manage it well, you can have a successful investment. When you educate yourself of the risks and benefits of your 401(k) plan, you can take advantage of these benefits as soon as they become available to you.
Here are some tips that can help you maximize your 401(k) plan savings:
- Start saving with a 401k plan as early as possible, even if you cannot allot a large amount of finances to your plan.
- Maximize employer matching contributions, where available, up to the maximum that your employer will invest.
- Take advantage of compounding interest on your 401(k).
- Take the time to explore savings rates and determine your financial goals.
- Diversify any investments that you make to grow your 401(k) more effectively.
The most important thing that you can do to protect and grow your 401(k) is to research your options carefully and choose the appropriate savings plan for you as there is no “one size fits all” when it comes to 401(k).
The more you know about your own financial goals and your 401(k) plan, the more likely you will be to successfully navigate through this common savings method and maximize your investment.