In the midst of a long-term career, retirement seems more like a dreamy idea than an impending event. If you haven’t started planning for retirement, don’t worry – we’re here to help!
Your employer likely offers a 401k retirement plan, which allows you to save and invest a portion of each paycheck before taxes. Continue reading to learn the importance of contributing to a 401k plan.
How do you save money in a 401k?
Here are a few tips on how to build your retirement fund with a 401k plan.
Tip #1: Don’t Wait
If your employer offers a 401k retirement plan, enroll as soon as possible. The earlier you begin setting aside money for retirement, the better. Whether you’re in your 20s or are a seasoned employee, it’s never too early to enroll in your 401k. This ensures you set aside enough money for the future.
Tip #2: Increase Your Contributions
If you’re just starting out in your career, your monthly retirement contribution probably won’t be much. No contribution is too small. The exact amount you set aside depends on your income, expenses and financial history. Consider increasing your contributions by 1 percent each year. This slight change isn’t too noticeable and makes it easy to grow your savings.
Tip #3: Move Money Around
With a 401k plan, you choose how to invest your money. You invest in various assets, such as stocks, bonds and mutual funds. As time passes, different assets perform better than others. It’s a good idea to review your funds from time to time to rebalance your asset allocation. Some 401k plans have automatic rebalancing, so ask your human resources department if this is available when you sign up.
Learn About Types of 401k Plans
There are a few different types of 401k plans available. Your company may let you choose which type of account to invest in or only offer one plan to all employees.
Traditional 401k
This employer-sponsored retirement plan allows you to choose how to invest. Any contributions you make to a traditional 401k are tax-deductible, and you only pay taxes on the money when you withdraw funds. Some employers match employee contributions up to a certain percentage.
Roth 401k
Roth 401k plans are also employer-sponsored and permit you to choose how to invest your money. However, the contributions you make are not tax-deductible. Instead, you contribute funds that have already been taxed. Income earned in a Roth 401k, including interest, capital gains or dividends, is never taxed.
SIMPLE 401k
Small businesses with 100 employees or less can offer a SIMPLE 401k. Unlike a traditional 401k, employer contributions must be fully vested, or assigned, which means you fully own all funds in the account. Traditional 401k plans typically have a vesting schedule, where the funds are not completely yours until a designated amount of time passes.
401k Plans and Taxes
Investing in a 401k retirement plan affects how you are taxed and influences your take-home pay. The contributions you make to your traditional 401k plan are funded with “pre-tax” dollars. They are taken directly from your paycheck before it is taxed, which lowers the overall income on which you are required to pay taxes. The exact amount that is lowered depends on your income and your tax bracket. With a Roth 401k plan, your contributions are taxed, but the total amount you withdraw is tax-free.
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With a traditional 401k plan, the money you invest is not taxed until you withdraw it. All withdrawals you make are taxed at your regular income tax rate. Withdrawing early from your 401k plan is never advised due to the penalties involved.
Each year you work, you receive a W-2 form that includes all income earned for that tax year. The form includes information about your 401k contributions, which are not taxed. As such, your earned wages subject to federal income tax are lower, which means more take-home pay. You can’t deduct your contributions when you file your tax return, but you can calculate the amount of money your contributions saved you.
Early Withdrawals From Your 401k
A 401k plan is designed to help you save money for the future. Sometimes, emergencies call for you to withdraw money from your 401k. Before you do, it’s important to understand the rules and limits for withdrawing funds from your 401k retirement plan.
To dissuade you from taking money out of your 401k plan, the federal government limits withdrawals to extreme situations. These include financial hardships, medical expenses, plan termination, job severance or death or disability.
Even if you qualify for one of these reasons and you withdraw money from your 401k plan before the age of 59 ½, you immediately pay taxes on the amount. If you do not qualify and still withdraw, you must pay the taxes along with a 10 percent early withdrawal fee. That adds up to a huge chunk of change, so it’s never recommended to withdraw early.
One alternative to withdrawing from your 401k is borrowing against it. Taking a loan against your retirement plan allows you to avoid the taxes and penalties. However, you must still pay back the money into the account. If you leave your job with an outstanding loan, many employers require you to pay in full immediately. If you cannot, the loan is considered in default and you are subject to paying taxes and a 10 percent early withdrawal fee.
Other Employee Savings Options
There are several other options for employees looking to save money for retirement. Employers choose which plans they offer their employees, so your company may or may not offer one or more of these savings plans.
Defined Benefit Plans
Some employers offer defined benefit plans, also known as pension plans. During your retirement, your pension plan pays a specific amount in benefits. This can be a fixed amount or dependent on years of service and other factors. Pension plans vary dramatically between employers. If your company offers a pension plan, read the summary plan description (SPD). This outlines how your benefits are calculated, when payments are made, when benefits are vested and how to file a claim for benefits.
403(B) Plans
Some employers offer 403(b) plans in place of a traditional 401k. These include public education institutions, nonprofits, churches and church-related organizations. Like a traditional 401k plan, you can contribute pre-tax dollars to a 403(b) plan and only have to pay taxes upon withdrawal. The main difference between a 403(b) and a 401k is that you pay less in administrative fees for 403(b) plans because most employers offering this type of savings plan are non-profit organizations.
Employee Stock Ownership Plan (ESOP)
An ESOP is a defined benefit savings plan that awards employees with an investment into the employer’s stock. You do not pay tax on contributions to the ESOP; however, you do pay tax on the distribution of your accounts. The tax rate is generally lower. You are also permitted to roll over the distributions into an individual retirement account (IRA) or other retirement plan. Like a traditional 401k, you are penalized 10 percent for withdrawing early.
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