If you've recently started your first job or started a new job that offers a retirement plan, you'll start to wonder whether you need one and how it all works. A retirement plan allows you to set aside money out of your paycheck every month to save for your retirement. You can also invest in other types of assets, including stocks. Over time, your invested money will grow so you can have a nice nest egg when you retire. Here's your guide to help with your retirement plan.
Definition of a 401(k)
A 401(k) is a retirement savings account offered by employers to their employees. It's tax-advantaged, which means you won't pay taxes on any of the money within it. Once you enroll in a plan, automatic contributions will be made from your paycheck into your account. These contributions may also be matched by your employer, which means you'll get additional money put into the account. Your investment earnings are not taxed until you withdraw the money.
Who is Eligible for a 401(k)?
Employers do not legally have to provide retirement plans to their employees, but it is a highly sought after employee benefit that can help them attract top talent. You'll know if you're eligible for a 401(k) or if your employer offers one typically during the first round of interviews you go to get your job. It will also be mentioned again during onboarding and in your employee handbook. If you're not sure whether your company offers a 401(k), you should ask the human resources manager as soon as possible.
Contributing to a 401(k)
Contributions to a retirement plan are subject to limits set by the IRS, but the employee and their employer can contribute until that limit is reached. A pension may sound similar to a 401(k) because a retired person uses their pension to fund retirement. However, these are not the same type of retirement plans. A pension plan is a type of benefit plan in which the business pays the employee a set amount when they retire.
Many businesses, large and small, offer a 401(k) to employees because it's efficient and eliminates the employees' stress of saving for retirement on their own. Employees can choose a variety of investments in their 401(k) plans and must choose between the employer's options. The employer's choices typically include mutual funds for stocks and bonds and a mix of stocks and bonds.
How much you can contribute to your retirement plan every year changes year over year to account for inflation. For 2020, the maximum contribution for employees under the age of 50 was $19,500.
If the employer also contributes or employees want to make payments into the account, the numbers may vary. However, your plan might not allow it because there are many types of 401(k) plans.
Employees contribute to their retirement accounts monthly, and employers sometimes match those contributions. If employers choose to match contributions, they typically match the same amount up to a particular portion of the employee's salary. If your company offers a 401(k) match and you have the financial ability to invest the full amount into it, it's recommended to do so to take full advantage of the company match.
If you deposit any money into your 401(k), you cannot withdraw it for free. Depending on your salary, everyday expenses, and budget, you may not want to invest as much as the maximum into your retirement account. If an emergency happens, you'll have to pay a fee to take that money out, which means you'll have even less money for retirement. Instead, set aside money out of your retirement plan for emergencies or large purchases and consider your retirement money inaccessible until retirement.
Everything you earn, including employer contributions and interest, is tax-deferred, which means you won't pay anything on it until you withdraw the money. However, earnings in a Roth 401(k) are tax-free no matter when you take the funds out because the funds were already taxed when you contributed it.
You can start taking money out of your retirement account when you retire or beforehand for a fee. If you're taking it out for retirement, you'll likely have to arrange plans with the company that manages your 401(k) to ensure you get your withdrawals as a check or direct deposit. This company will also handle your taxes for you, so it'll be just like getting a regular paycheck without the work that comes with it.
If Your Employer Doesn't Offer a 401(k)
If your employer doesn't offer a 401(k), you can still save for retirement on your own and set up a similar program with an investment firm or open an IRA at your local bank. These retirement accounts work similarly to a 401(k) in the sense that you put money into an account, and it grows intending to save money for retirement.
However, if you take out a savings account from a bank, the money doesn't come directly out of your paycheck; instead, you'll have to take it out of your checking account and put it into your savings account at scheduled intervals. Some banks allow you to take money out of your checking account and put it into another savings account automatically on the same date every month, but some require you to be a little more diligent and do it on your own.
If you invest in a retirement account outside of work, you can deduct your contributions when you file your taxes every year. You might want to invest in tax software to help you keep track of your payments so you can deduct the correct amount from your taxable income. An IRA is easy for those who already take deductions, such as small business owners and freelancers.
Saving for Retirement
Financial experts agree you should take advantage of any retirement plan your employer offers and start saving money as soon as possible. Retirement is expensive, and a regular check coming in can ensure you're financially comfortable when you're no longer working.
About the Author
Matt Casadona has a Bachelor of Science in Business Administration, with a concentration in Marketing and a minor in Psychology. Matt is passionate about marketing and business strategy and enjoys San Diego life, traveling, and music.