What is one thing that scares almost all young people? Here’s a hint: it is something that might seem very unimportant now, but it will hit everybody hard eventually. It will probably be essential to your future. It might scare you because, if you are really young you may never have experienced it or you might just not know how it works. Did you get it yet? Okay fine, I will tell you. The answer is: the 401(k) plan. Yes, that is right, the dreaded (but totally useful if used correctly) 401(k) plan.
Let us be clear here: most working Americans could have 401(k) plans. In fact, nearly 80% of full-time American workers and large companies have access to employer-sponsored retirement plans such as the 401(k). And 87% of those workers actually take advantage of that access by using their plan. But, while these plans are widely used, they are not widely understood. Hence, the “dread.” We assure you, they’re not as “dreaded” as they may seem if you know how to use them. If you don’t understand or know how to maximize your 401(k), this is the article for you.
WHAT IS A 401(K)?
To use your 401(k) plan to your advantage, you should start by knowing exactly what it is and how it works. A 401(k) plan is a retirement plan offered by most employers that allows employees to save and invest for their own retirement by allocating money from their paychecks. The money is put into a savings fund called the 401(k).
It is the employee’s decision to decide when to begin contributions and how much of their paycheck is contributed to their 401(k). Even better, employers will sometimes match the funds that the employees add. What is really cool about this plan is that money is withdrawn from your paycheck before taxes are taken out, allowing you to save more of the money you make. With these tax breaks, it makes sense to invest as much of your income as you can into your 401(k). Ultimately, you will pay the income taxes back once you withdraw money from your plan.
WHAT IS A ROTH 401(K)?
For simplicity sake, a Roth 401(k) is the same as a traditional 401(k) except for the fact that you pay taxes prior to putting your money into a Roth 401(k) and; therefore, do not need to pay taxes when you withdraw your money in retirement.
INVESTMENTS FOR LATER
Basically, a 401(k) is an investment account that you can access later. Once you have a 401(k) and have contributed money to it, it is up to you to decide how your money is invested. Typically, your employer or your plan has limited you to a pool of mutual funds from which you can choose. (Note: your employer will provide you with information about the funds. Read it!)
Depending on your timeline, you should figure out how much risk you will be willing to take with your retirement savings. Remember: you are not guaranteed to get back the money you put in if you make risky decisions. However, if you are an investor with a long time horizon until your retirement, you might consider taking your chances with riskier investments because there is a greater reward potential.
WHEN CAN YOU GET YOUR MONEY?
Most plans don’t let you withdraw your money (without penalty) until you are almost 60 years old. This assures that you will leave the money for your retirement, which is a good thing. However, if you’re really in need of money, your plan may allow you to withdraw some “penalty free” (without charge for taking it out early). For that reason, it’s good to read all of the materials that come with your plan!
If you end up switching jobs, your best moves are to either to switch your money to an IRA account (see the next section) or ask your new employer if they will sponsor your current plan.
WHAT IS THE DIFFERENCE BETWEEN A 401(K) AND AN IRA?
An IRA essentially removes the middleman – your employer – from your retirement savings fund. Without the employer, you are going straight to an investment firm. While this removes the opportunity for the employer to match your investments, it allows you to have a lot more freedom over how you invest your money for retirement. Individuals can typically decide which course of action to take regarding retirement savings depending on their money spending or saving habits.
At the end of the day, knowing how these different investing plans work could really help you save for retirement. By knowing your own preferences regarding spending and saving, you can pick the plan that will help you maximize your retirement fund. Plus, investing in retirement funds and personal investing go hand in hand. The more you do one, the more knowledgeable you’ll be to make decisions regarding the other! Start saving and investing – the more you learn today, the less you will “dread” starting tomorrow.