Some of us might have learned about 401(k)s in school, but a lot did not. We’re breaking it down, so consider yourself clueless no more. Here’s the 411 on a 401(k).
What Is a 401(k)?
To put it simply, a 401(k) is a retirement savings plan that is typically offered by an employer. It also comes with some tax advantages. When you sign up for a 401(k), you agree to have a percentage of your paycheck deposited into an investment account; your employer can opt to match part or all of your contribution.
There are two types of 401(k)s – Roth and traditional – and they differ slightly in how they’re taxed. With a traditional 401(k), your contributions are pre-tax, which means they reduce taxable income, but if you dip into your 401(k) and make a withdrawal, that action can be taxed. Roth 401(k)s are a little different: The contributions to the account are made with after-tax income, which means there is a tax deduction in the contribution year, but any withdrawals are tax-free.
How to Set Up a 401(k)
It’s important to know that even though these accounts are offered through your employer, they don’t automatically get set up for you. Instead, they tend to leave the investment decisions up to you, so make sure you inquire about this during orientation and ask questions about anything you don’t fully understand.
- Sign up. Some employers enroll employees automatically, but others don’t. It’s best to inquire about the process. Typically, you’ll start with a low contribution amount, somewhere around 1%-2%, then increase the amount by 1% annually until you opt out.
- Next, choose what kind of account to open: traditional or Roth.
- Review your investment choices. Since your 401(k) exists to hold your retirement funds, you can put into the account whatever you choose within the limits of your plans. You usually receive a list of 10-20 investment options to make this step easier.
What Are the Advantages of a 401(k)?
Tax Advantages
The money you contribute to your 401(k) comes out of your paycheck before taxes. This is beneficial because this lowers your taxable income. What that means for future you is that you may owe less in income tax, and you may even be in a lower tax bracket.
It *Typically Only Goes Up
The earlier you start investing, the more time your money has to grow. This is called compound interest, which is basically getting interest on interest, and this can add up in the long run once retirement hits.
It’s With You for the Long Haul
Even if you don’t plan to stay at your job forever, the money you invest will remain with you. Plans vary, so once you have a new job, find out your options for leaving your plan in place or moving it with you.
It’s Easy
Few things in life are as easy as building up your 401(k) because the money comes out of your paycheck before you even get a chance to miss it. And if you ever find yourself thinking about that money, find comfort in knowing you’re investing in your future.
401(k) Tips
- Take advantage of a 401(k) if your employer offers it – and whatever match program they have.
- It never hurts to meet with an investment expert to ensure you understand what you’re doing and ensure that you’ve made the best decisions when setting up your 401(k).
- Sometimes, emergencies require quick money, and if your 401(k) is your only option, you can take a loan out of your 401(k) and then make it your top priority to pay that money back.
- Cashing in on your 401(k) comes with a number of penalties, all of which have to do with taxes, so it’s best to leave that account alone until you retire.