401k is a term you will hear a lot when your career starts getting underway. As millennials grow older, we will begin to start thinking more and more about our futures, and the things we need to do in preparation for them. Finances play a huge part in that – maybe the most important part. That’s because you can’t retire to your beach house if you don’t have money pre-prepared for it. So in comes your retirement plan, better known to most people as a 401k. Before we get started, it is important to know that this is not to be seen as advice. Everyone’s financial situation is unique and therefore cannot always follow the same path.
What is a 401k ?
A 401k is a retirement plan offered by your job; many employers will offer their employees this plan. It allows you to put away salary deductions from your paycheck for your retirement, before tax. Depending on how long you stay with your job, in some 40 or so years down the line you will retire and accrue whatever amount of money you saved and then pay the taxes. With a 401k you can secure your future during retirement and not have to worry about finances when you’re done contributing to the workforce. But what exactly is it and why do we need it?
We need it because most of us are not going to work forever. And in the case of early retirement or unpredictable health issues, you never know when you will need to rely on money to get you out of something when you have no backup plan.
There are two types of 401k’s: a traditional and Roth. Both are similar with different benefits. The traditional plan gives you the opportunity to put away money from your paycheck before it is taxed. You will only pay taxes when you make withdrawals at efile time.
In the Roth plan, the contribution is after-tax and withdrawals are not taxed. Account holders can start making withdrawals in both plans after turning 55, but with 10% penalties (some exceptions). Penalty-free withdrawals are after you reach 59 ½. Sucks right? But wait…this is actually the best way to secure your finances as you age. With the Roth 401k, since you invested your money after it was taxed, you do not have to pay taxes on your retirement money, and this is important as it concerns the future and tax increases. Even if taxes increase, with a Roth you do not have to worry.
How Do You Get One?
You can usually get a 401k plan through your employer. If you started a new job, they may ask you to contribute your first week, or you might have to wait a certain time period before you are eligible. All employers do not offer these plans, and you may need to think about an Individual Retirement Plan (IRA), which somewhat differs from a 401k. But luckily if your employer does sponsor retirement plans, you do not have to worry about that.
The first thing to think it about before getting a 401k is whether you want to save up for retirement, how much you want to be deducted from your salary for your plan, and if you can afford it. Those are three important things to ask yourself, because if you’re 25 and do not want to start saving until you are…say 30 years-old, then a retirement plan is the last thing on your mind. Then again, if you do want to start saving, you have to think about how much you want to contribute every month. A lot of people contribute somewhere between 5-10% of their salary. The higher the contribution, the more money will be in your retirement. But the most important of all, can you afford it?
If you are living from paycheck to paycheck and counting on every penny you earn, it may be extremely difficult for you to save up for retirement now, and this likely means you cannot afford it. Which is why it is important to save what you can without further adding any burdens to your finances. If you have to start at 1% because you don’t have the funds to save more, guess what? It’s better than nothing.
How Do You Manage Your 401k?
When your employer sponsors your plan, they choose a mutual fund company that will manage it for you, such as companies like Fidelity, HSBC, and Prudential Investments. A mutual fund is a pool of money that investors can invest with into stocks and bonds. Your money will be professionally managed by these investors, who can increase the value of your plan.
Before taking the plan, find out what your employer will match. A matching plan is what your employer will contribute to your 401k – some employers will match what you contribute fully or only match half of it. So, if you learn that your employer matches at 6%, you should contribute 6%, and therefore get the full employer benefits to your 401k. Always take the full match your employer will contribute towards your plan.
You can properly manage your plan by also increasing your contribution as much as you can. This is especially important when you get a raise. Raising your contribution 1% every year will allow your 401k to grow over time as you gain. Another important thing about managing your plan is to avoid taking money out of it unless you really, really, really, and desperately need it. Most financial experts highly recommend against it.
Lastly, if now or in the future you have to leave your job for another, you can rollover funds from that 401k into a tax-deferred account or an IRA, and continue contributing to it. However, it is always best to research your options beforehand and think about which one is best for you.
Are you contributing to a 401k sponsored by your job? What additional tips should we know?