What is a 401(k) retirement plan?
So you don’t know what a 401(k) is? Don’t worry, I’ve got you covered. I’ll first break down how it works, then go into greater detail. A 401(k) is a retirement investment plan offered by employers to employees as an incentive to invest for retirement. Employers typically match a percentage of an employee’s contribution in the retirement plan. The lingo of the 401(k) plan is found within your benefits package.
So what exactly am I contributing into?
You’re contributing to an investment fund which is essentially a mutual fund. There are several investment styles to choose from, which range from more conservative (lower investment returns, lower risk of losing investment) to more aggressive (higher investment returns, higher risk). Employees who are younger in age have more time to recover losses and typically will take an aggressive approach. While those that are older and more risk averse, will typically take a more conservative approach. You have an array of choices to choose from and you can also contribute to more than one investment fund.
Why should I contribute to my 401(k)?
The number one reason you should contribute to your 401(k) is there are very few investment opportunities that give you so many benefits. When contributing, you receive 1) a tax benefit, 2) free money, and 3) more money for your 65 year-old self. I’ll break it down further for you.
There are two types of 401(k) plans: Traditional 401(k) and a Roth 401(k). The main difference between the two comes from the timing of when you are taxed. For Traditional 401(k) plans, you are taxed once you withdraw from your retirement plan (when you retire), but not when you contribute to your plan. For a Roth 401(k), you are taxed when you contribute, but can withdraw from your retirement account tax-free (note: you can withdraw from your retirement plan earlier than 65, but this will trigger an early retirement penalty). You can choose to contribute to either plan or even both if you would like. It all depends on what tax rate you believe you will be taxed at when you hit age 65.
Free money comes from your employer. Employers match a percentage of your contribution (or annual income) in a retirement plan. When reading your benefit plan you may see something along the lines of,”100% of the first 2% contributed and 50% of the 2% of max contribution…..”. Which means if you were to make the maximum contribution in your benefit plan your employer would match a total of 3% to your retirement plan ((100%*2%) = 2% + 1% (50% of 2%) = 3%). Still confused? Let’s do the math.
Let’s say your annual income is $50,000 and your max contribution is 3% (or $1,500). Your employer would match your contribution by $1,500. That’s an extra $1,500 going into your retirement! So when you hear people say,”Max out your 401(k) contribution, don’t leave any money on the table…”, that’s what they mean! If you didn’t contribute at all to your retirement, you would be walking away from an extra $1,500. I for sure would never leave that kind of money on the table.
More Money For your 65 year-old Self!
For every contribution you make in your retirement plan, I want you to think about your 65 year-old self. I want you to take a look at the chart, courtesy of the Investor Field Guide (they have some good info by the way!). This is the potential every dollar is capable of when you contribute to your 401(k).
If this chart does not give you motivation to contribute to your retirement plan, your 65 year-old self will be in a load of trouble. As you can see from the chart, the younger you begin contributing the better. At the same time, it’s never too late to begin. If your employer does not offer a retirement plan you can always open an individual retirement account (IRA) which will give you an additional tax benefit.
With an IRA you would be able to deduct up to $5,500 of contributions per year if you’re under 49 and $6,500 if you’re over 50. Please note, you would only be able to do this if you contribute to a traditional IRA compared to a ROTH IRA. The rules of a 401(k) account are still in place. For further explanation on contribution limits, the IRS has a plethora of information for you to dive through. If you found anything in this article intriguing or like to add more insight into retirement plans feel free to leave a comment below!