The 401k is a common enough term, yet many still have a minor understanding of what it truly means.
That may be expected when so many factors go into a 401(k) including tax implications, fund allocations, contribution amounts, and employer matching.
Put simply, the 401(k) is a retirement plan that is offered by your employer that allows you to contribute part of your salary on a tax-deferred basis.
Should you take your retirement seriously then learning about your 401(k) can show you where you can best apply your earnings.
In this guide, we will look at the basics of a 401(k), the benefits, and the factors that could affect your retirement plan.
Introducing The 401(k)
As a retirement plan, the 401(k) can help an individual reach their retirement amount and target retirement date in good time.
This is largely through what type of investment funds are involved to make ideal fiscal sense, essentially whether you want an aggressive or conservative approach.
Decide the percentage of your paycheck you want to contribute to your 401(k) and how often you want to make a contribution.
Once you hit your retirement age, you should have a healthy investment to withdraw without suffering a penalty.
You should be offered a 401(k) once you begin employment at a mid to large-sized private company.
This will be the beginning of a path to your retirement in a tax-advantaged plan to allow you to put money away through payroll deductions.
Due to its flexibility and ease of use, the 401(k) is largely the preferred plan for retirement for many employers and employees, instead of traditional pension plans.
The Benefits Of A 401(k)
Should you be curious about starting a 401(k) then you should be aware of the benefits you can get from such a retirement plan.
A Tax Break For Contributions
Most of the appeal for a 401(k) comes from its tax break so the funds leave your salary before tax have got a chance to be levied.
That should cut your tax bill by lowering your taxable income and it should be seen as ‘pre-tax dollars’. That’s right, the contributions are allowed to grow without being taxed which can only boost your savings.
However, it should be noted that contributions to a 401(k) are a tax break in a tax-deferred account, the retirement plan itself is not strictly tax-free.
A Possible Loan
A 401(k) is effectively your own money and your plan may even offer the chance of a 401(k) loan which can be appealing in certain situations.
Especially if the interest rates are set at a prime rate with an added one percent. As you are effectively borrowing from yourself, the interest should go back to yourself.
Only consider the loan if you truly need it as there are rules set by the IRS including repayment rates and you would need to remain with the company that your 401(k) is set with.
The Factors That Could Affect Your 401(k)
While there are some clear benefits to starting a 401(k), there are several factors that you should be aware of.
Though the 401(k) is a tax break, there are still fees to pay to maintain it. A lot of savers are not aware of this, and they can typically range from 0.5% to 2% of the individual plan’s assets.
The fees can also be higher than that, so it is worth checking the small print before you begin contributing. If the 401(k) is a relatively small plan, the fee could be higher to maintain it.
Should you want to take a keen interest in your 401(k) then take a look at the available investment choices. There will be several options on how you want to allocate your contributions.
However, if you do not take a choice, your contributions will have defaulted to a specific fund that is based on a target date or a money market.
The funds could be in domestic bonds, international stocks, domestic stocks, and money markets.
The most popular funds tend to be target-date based, which typically go from a stock-heavy basis to one heavily based on bonds for a more conservative approach.
If you want more control over your contributions, then make a choice on the fund.
The contribution limits perhaps mean more to individuals who are nearing retirement. As the 401(k) remains such a popular and well-renowned savings tool, it should be a plan that is gradually built up.
With that in mind, be careful of contribution limits as there is only so much you can put into a 401(k) and the IRS sets an annual limit.
Even if you have over $20,000 available and ready to contribute, you may not be able to do so in a single year.
You may even be in a 401(k) without even realizing it if your employer automatically signed you up.
Over half of companies are doing so to ensure that staff have a retirement plan in place with some regular contributions.
Of course, if employees do not want to be in their company 401(k) then they can opt out.
However, these auto-enrolled plans typically include deductions that increase contributions which is known as auto-escalation.
Retirement may seem a fair way off, but it is worth planning ahead. A 401(k) is a good option to consider if you have begun your career, as you can set one up with your employer and then simply let it grow.
Within a few years, when you are closer to retirement, you can consider your options with funds, contributions, and even a loan.
Your first option may simply be to check with your employer how their scheme works and if it works for you.
Frequently Asked Questions
What Are The Major Disadvantages Of A 401(k)?
While a 401(k) should seem appealing, there are some disadvantages when they are compared against each other.
These typically include a tiny or even non-existent company matching contribution, high fees, few investment options, and difficulty to access your funds.
There are also tax implications should an individual decide to make a withdrawal from their 401(k).
What Is A Superior Alternative To A 401(k)?
If the 401(k) is not the retirement plan for you then consider a qualified investment account or an IRA (individual retirement account). These also offer tax benefits for those saving towards their retirement.