If your employer offers a 401(k) plan, it is a great way to build retirement savings. It gives you access to a professionally managed investment and administrative structure that can help you start your retirement savings program without a lot of planning or experience as an investor. That's key, because getting started may be the most important step you can take toward a financially secure retirement.
The following are answers to some questions about 401(k) fundamentals. Knowing this basic information can go a long way toward helping you take that first step of saving for retirement.
What are the benefits of having a 401(k)?
Since 401(k) plans are tax-deferred retirement savings plans, the portion of your wages that goes into the 401(k) plan is exempt from taxes. You will eventually pay taxes on your 401(k) money when you start to take it out of the plan, but since people are often in a lower tax bracket in retirement than during their careers, putting taxation off until retirement can work to your advantage. Plus, in the meantime your 401(k) money is free to grow through investment without year-by-year taxation on gains and income.
The benefits of having a 401(k) are greatly increased if your employer makes matching contributions. Matching contributions are discussed in greater detail below, but they represent money your employer will put into the 401(k) plan on your behalf to add to your contributions. This instantly magnifies your retirement savings.
Finally, 401(k) plans provide access to professional management and administration that could be too expensive for many individuals to afford on their own. This includes being able to choose from a range of managed investment options and being able to use retirement calculators and other tools to help make retirement planning decisions.
Are there any drawbacks to investing in a 401(k)?
You should look at contributions to a 401(k) as a long-term commitment, because if you take the money out before you reach age 59 1/2, you will most likely have to pay a 10 percent tax penalty on that money in addition to ordinary income taxes.
For this reason, it's good to have other savings outside of your 401(k) or other retirement savings plans, so you will have ready access to it in case of an emergency.
How much can I contribute to my 401(k)?
For the 2019 tax year you can contribute up to $19,000 to your 401(k). This does not include any matching contributions.
If you are aged 50 or older, you can contribute an additional $6,000 to your 401(k), for a total of $25,000. This additional contribution is known as a catch-up contribution because it is designed to help older workers who are nearing retirement get caught up on their retirement savings.
The amounts for the 2019 tax year are subject to change in future years due to inflation adjustments and/or legislative changes.
How do employer matching contributions work?
Not all employers provide matching contributions, but those that do usually apply a set formula to the amount you contribute to determine how much the employer will add.
A common formula is for the employer to contribute 50 percent of the amount the employee contributes to the 401(k). So, under this formula, if you contribute $5,000, your employer will add $2,500 to that for a total of $7,500. Sometimes the amount of the employer match is capped, so the formula would only apply up to a certain dollar figure.
There may be vesting requirements tied to employer matches, meaning you may have to participate in the plan for a certain period of time before you are eligible to keep employer contributions if you change jobs. However, the amount you contribute to the plan is yours to keep if you leave your employer.
Getting an employer match is a great incentive to contribute to a 401(k) plan because it instantly increases your compensation if you participate.
How should I invest my 401(k) money?
You are most commonly presented with a menu of investment options ranging from low-risk to high-risk. Generally speaking, the younger you are, the more risk you can afford to take; but this is also a function of how comfortable you are with investing and how much you've already saved for retirement.
Some plans make it especially easy by offering managed-allocation or target-date options. These provide a mix of stocks, bonds, and liquid investments tailored to a specific risk profile or target retirement date. The investment manager usually takes care of adjusting the investment mix over time. Since asset allocation is one of the most important investment decisions one has to make, professionally managed allocation funds are a good option for investors with less experience.
How often should I change my 401(k) investments?
The beauty of long-term retirement savings plans is that they are conducive to setting a long-term investment course that doesn't require a lot of adjustment. If you find yourself tempted to frequently tweak your 401(k) investments, it may be a sign that you are being overly influenced by short-term market changes or other developments.
Investing is a lifetime learning exercise, so don't think you have to be an expert in order to get started. Once you start working with your 401(k) plan you should become more familiar with it and perhaps start to explore more details about retirement saving and investing. However, whether you choose to become an expert or remain a casual investor, just participating is enough to get the benefits of having a 401(k) working in your favor.