Your employer might offer a 401(k) plan, which allows you to save tax-free for retirement. The main benefit is that you can let your savings for retirement grow without taxes. Plus, you can gain other advantages. Compared to individual retirement accounts, such as IRAs, you might find that 401(k) plans offer you more benefits. You will also want to understand Roth 401(k) plans.
Understanding a 401(k) Plan
A 401(k) plan is named after the tax code that brought it to life, and it is a savings program you can choose to contribute. Your employer offers the plan, and you can choose to participate if you like. When you decide to do so, you will have a certain amount taken out of your paycheck and sent to the investment account. You can pick from investment options such as target-date funds, mutual funds, or exchange-traded funds.
You will contribute to the plan with your pre-tax dollars, so the money will come out of the income before calculating income tax. Since pensions are not as common these days, more people are participating in these investment vehicles.
Tax Benefits of a 401(k)
There are a few different tax advantages of a 401(k). First, you offer contributions to it before you pay taxes. The only taxes you will pay on the funds will be once you have retired. The earliest you can withdraw from the plan is when you are 59.5 years old.
Since the contributions are not counted as your income, you might end up in a lower tax bracket. That means your taxes will be slightly lower since you will have some funds put away for your retirement years.
The savings also grow without you having to pay taxes on them. If you have a typical investment account, the dividends and net gains will get taxed. However, with a 401(k) plan, the earnings can grow without being taxed as long as they are still in your plan. And with compound interest, the earnings on your payments can also increase. Just remember that you will owe taxes once you take the funds out. However, by that point, you might be in a lower tax bracket.
The benefits of a 401(k) plan cannot be overstated. I used the WealthTrace Retirement Planner to calculate how much a 35 year old will have when he is 65 if he maxes out his contributions and gets a $5,000 match each year. I found that he will have $2 million at age 65 if his returns average 7% per year.
Company Matching the 401(k)
Employers often match the employee contributions, whether that is a percentage of each dollar or dollar for dollar. They will often match your contributions up to a specific limit. By doing so, the employer can encourage individuals to sign up for their plans. Another advantage for the company is that this plan can help retain talent.
No matter your employer's reason for offering the match, the money is free, and you might not have gotten it otherwise. The employer's contributions and your earnings are both tax-deferred, so you will not need to pay income taxes on those until you have withdrawn the funds.
Advantages for Later Savers
Even if you did not begin your retirement savings as soon as you began to work full-time, you could still get some advantages. If you are in the middle of your career, you are not alone. If you are age 50 or more, you can catch up to your contributions by several thousand dollars, in addition to the already allowed amount of $19,500. That is a bit more than what you can put into an IRA, even if you are catching up.
If you have not started saving until now and want to keep working while contributing to the account in your 70s, it is possible to do so. Still, a traditional IRA does not have these advantages. You need to take the minimum distributions once you are 72 with an IRA.
Fiduciary Benefits
A 401(k) plan is under the Employee Retirement Income Security Act, meaning an employer needs to put your best interests first. That means the administrators of your plan have to meet the fiduciary standard. Even though they don't have to have the lowest possible costs, they need to extend reasonable offers. You will so have table investment options, and information on the fees will be disclosed upfront.
Getting a Roth 401(k)
Sometimes, companies offer Roth 401(k) plans as well. You will find them after taxes, so you will not reduce your taxable income by contributing to them. Still, they can grow tax-free, and you will not need to pay taxes on either the contributions or the earnings on those. Just remember, if the company matches them, you would still owe some taxes on them. You can withdraw without a penalty once you have the account for five years or longer.
Tips for Managing a 401(k)
You might think that after choosing the best investments for your 401(k), you are all done. However, you will need to continue assessing the location of assets. For instance, what percent is in fixed income and what percent is in equity? You will then want to ensure your assets are balanced correctly.
If you retire or switch jobs, you might choose to roll the 401(k) to the new plan offered at your job. That might be difficult if you have a large account, but it is possible and beneficial to do so.
Closing Thoughts
Keeping your savings in a 401(k) can help you prepare for retirement. If your employer offers to match your contributions, it is free money for you. The earnings can grow with compound interest, and you will receive tax advantages as well. No matter where you are in your savings journey, now is the time to start saving as much as you can.
