A 401k is an employer-sponsored retirement savings plan that encourages employees to invest part of your paycheck, pre-tax, into an investment account. This account can grow, tax-free, until you are ready to start withdrawing from it. You can take it as early as age 59 ½ and you have to start taking it at age 72 (called a Required Minimum Distribution or RMD).
Most plans are made up of mutual funds or ETFs that include stocks, bonds, and cash investments.The contribution is taken directly from your regular earnings so it’s a fail-safe way to save consistently. Simply determine the right percentage or amount of your salary you want to contribute each month and it will automatically go into this account for investment.
While your employer chooses the specific investment lineup to pick from, the plan administrator can help you pick the right allocation for you. Another hidden benefit to the 401k is that contributing lowers your taxable income. If you earn $4,000 a month and invest $500 into your 401K,the government can only tax you on the remaining $3,500. That will effectively reduce your taxable income by 12.5%.
Many employers will offer a company match. For instance, if you add 6% of your income your employer can match that amount up to 3%. That free money to the participant that can really add up to some serious amounts over time. It is critically important to find a way to take advantage of this component of your retirement planning so every effort should be made to qualify for this.
This year, you can invest up to $19,500 a year in your 401k. For late starters over 50, a catch-up amount is granted allowing that group to contribute up to $7,000 more for a total of $25,500 per year. So never think that it’s too late, it’s never too late.
What If I Leave My Current Job?
No one works at the same place for their entire career. On average, people change jobs twelve times over the course of their career. Can you imagine if you were forced to leave your money in each plan you contributed to? You don’t have to.
You have a few options such as: 1) some employers will allow you to leave the account, 2) you may be able to “roll it” to a new employer’s plan or your own IRA, or 3) you can cash it out. Cashing out is the worst option because you’ll have to pay taxes and pay a penalty for early withdrawal (if you’re under age 59 ½). The best thing to do is to transfer the money to an IRA rollover. There is no tax penalty for doing so, and you will have much greater control over your investments.
What to invest your 401K in?
Once you start contributing money to a 401(k), you will then have to choose investments. Though most 401k plans do not allow for single equity purchases like owning individual stocks, you will be able to choose from several mutual funds or exchange-traded funds (ETFs), which invest in a variety of companies, sectors and risk levels.
While there are thousands of funds available in the financial market, the investment committee at your company will choose a small selection of stock and bond funds, ranging from conservative to more aggressive. This is by design. Offering too many choices will almost always work against the investor with little experience. The investment committee will pick one good performing fund to represent several sectors and asset classes. The following are a few types of investments that you will find in a typical plan:
These funds, when used together, represent a “balanced” portfolio. Investors should strive for their portfolios to be diverse and the easiest way to achieve this diversity is through the use of index funds. For further diversification, bond funds offer investors exposure to less volatile fixed income securities. These funds focus on earning yield and will help stabilize portfolios in times of extreme volatility. If investors have little time or desire to devote to building and maintaining their portfolios, the use of Target Date Funds is the easiest, most set-and-forget way to ensure a proper allocation that will remain that way during your working years.
The Bottom Line
Building a retirement through 401k investing has become a must if you are offered this plan at your place of employment. The most important thing you can do is to make absolutely certain you maximize your company match.
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