Retirement is a dream for many and planning for it is an absolute necessity. If your employer offers retirement plans, you may be eligible for a 401(k) plan. But what do you do with your plan once you open it and what are the best strategies? This guide will break down a 401(k), how it works and how you can benefit from contributing to one.
Introduction: 401(k) Retirement Plans
What Are 401(k)s?
A 401(k) is a retirement plan that is sponsored by your employer. It has some tax advantages to it and you as an employee make a set contribution each pay period to the 401(k). The contribution you make is usually automatically withheld from your paycheck. Some employers will match a certain percentage of your contributions.
When you’re ready to retire and want to withdraw your money, your earnings can then be taxed. There are two types of 401(k)s: traditional and Roth 401(k)s.
Roth vs. Traditional 401(k)s
A Roth 401(k) is a combination of a 401(k) and a Roth IRA, or individual retirement account. In a Roth 401(k), you’re able to make your contribution after taxes have already been taken out and you can make withdrawals from your 401(k) without them being taxed.
A Roth 401(k) contribution can still be matched by your employer, so you can think of this particular retirement plan as a happy medium between the traditional 401(k) and IRA. A Roth IRA is funded with contributions made after taxes and withdrawals aren’t taxed. But the limit to how much you can contribute to a Roth IRA is lower than that of a 401(k). With a Roth 401(k), you can take advantage of an employer-sponsored retirement plan and enjoy tax-free withdrawals later.
How Does a 401(k) Work?
Your 401(k) contributions are taken out of your paycheck and depending on whether or not you have a traditional or Roth 401(k), this can be pre- or post-tax. Your contribution, plus any matching your employer provides, go into your account and are invested.
A 401(k) isn’t the same as a savings account, where money can sit and collect some interest over the years. A 401(k) instead invests your contributions to allow for a return. As the account holder, you’re able to choose what you invest in. There are a huge number of funds to choose from for your retirement plan, like target-date mutual funds. Usually, you choose your investments when you open for your 401(k) with your employer.
Over time, the investments in your 401(k) deliver a return. By continuously contributing to your 401(k), you build your nest egg little by little. Combined with any other investments you might have, a 401(k) can be an excellent way to ensure your savings grow consistently over time to prepare for retirement.
Once you’ve retired, you can withdraw from your 401(k) plan. If you’re over the age of 55, you can withdraw from the account without a penalty. Once you reach 72, you’re required to take minimum distributions from the account.
Learn How to Save at Your Own PaceChoosing the Best 401(k) Investment Plan
When you choose an investment plan for your 401(k), you have control over what exactly you want to put your money into. The best plan for you will depend on your risk tolerance, goals for retirement and what kind of return you’re looking for on your investment.
Like with any kind of investing, there are risks and rewards to the investment you choose. If you received a list of funds to choose from when your employer, they’ll most likely have a snapshot of each fund with a description included. A few examples of these funds include:
Exchange-traded fund (ETFs):
ETFs are index funds, usually for long-term buying and holding of stocks.
These particular mutual funds or ETFs are structured to grow by a certain targeted date in the future. This date ideally is when you plan to retire.
These mutual funds focus on specialized areas such as real estate and other commodities.
Aggressive growth fund:
These types of mutual funds seek high yields from growth stocks. They’re considered aggressive because they come with a high market risk.
A value fund is a type of fund that invests in stocks thought to be undervalued in the market. They’re often compared or contrasted to growth funds, which rely on growth stocks as an investment strategy.
A balanced mutual fund focuses on balancing out investments. A balanced fund contains stocks and bonds to diversify your holdings.
These are low-risk mutual funds that are structured to match or outpace the rate of inflation in future years. They’re ideal for investors with a low personal risk tolerance.
Money market funds:
Money market funds specialize in holding short-term securities like U.S. Treasury bills or Certificates of Deposit. These funds offer high liquidity and low risk, but are not insured by the FDIC.
Learn How to Save at Your Own PaceNotes for Choosing a Plan
While most retirement investment strategies exclusively include mutual funds, ETFs have become more common in recent years. Each one of these funds will have pros and cons to them for investing. They all come with their share of risk as well. If you ever have questions about investing for your retirement, you can always consult a financial advisor to see how you can maximize your returns.
Who Needs 401(k)s?
Frankly speaking, everyone should be preparing and saving for retirement if they can. However, 401(k)s aren’t the best fit for everyone. Traditional 401(k)s and IRAs can come with withdrawal penalties for retiring early (under 59 1/2) whereas a Roth IRA has no restrictions as long as the account is at least five years old. You’ll still need to wait until 59 1/2 to withdraw your Roth IRA’s earnings, but it’s worth noting that a Roth IRA has fewer withdrawal restrictions than a traditional 401(k) or IRA.
So who needs a 401(k) retirement plan? It’s best to take advantage of these plans if your employer sponsors a plan and it doesn’t come with high fees. If your employer offers a matching contribution to your own, then you’re guaranteed some savings each pay period. You can also supplement your 401(k) by opening an IRA. If you have the means to max out your 401(k) and IRA, then you’re in great shape to save retirement. The contribution limits for both of these accounts can change, so if maxing out your contributions is your goal, check the current limit on the IRS’s website.
How Much You Should Save With a 401(k)
So, how much should you contribute and save with your 401(k)? How do you know much you need to save? The answer depends on what you want your retirement to look like.
Do you want to move to a new state when you retire, or would you like to travel? Depending on where you live, you can stretch your dollar further due to the cost of living. Likewise, expenses like frequent travel and experiences should be factored into your budget. As a general rule of thumb, you’ll want to save 70-90% of your pre-retirement income. While you do this math, there’s also inflation to consider and the potential rate of return you’d like to see from your retirement investments. If you’re already planning to max out your 401(k) contribution limit, then you’re in great shape for the future. Even if you can’t from the start, gradually increasing your contributions as you earn more will help boost your savings over the years.
If you want to know exactly how much you need for retirement, you have a few options. There are many free calculators available that will help you visualize your future needs for retirement, but a financial or 401(k) advisor can also help you with a more tailored plan based on your specific needs and situation.
How to Set Up Your 401(k)
As a workplace-sponsored retirement plan, your employer will help you set up your retirement account once you become eligible. Your employer may also have resources available to you on the specifics of your plan and the plan administrator.
Your plan administrator will be the one to communicate with you if there are any changes to your 401(k) and send you any important information and documents, like tax forms. If you ever have any questions or concerns about your plan, you can reach out to your employer or the plan administrator.
Once you’re eligible for opening a 401(k), you’ll have to choose your contribution amount and what fund you’d like your contributions to go into. Depending on your employer’s match policy, you may choose to elect a certain percentage of your paycheck, not a flat number.
Conducting due diligence and research into the different funds available to your plan is key. Your personal risk tolerance and goals for return can all factor into your final choice. Funds are made of many different stocks, so some are more conservative than others in their risk. Once you’ve chosen the fund you want and start making contributions, you’ll receive reports on their growth and the status of your account’s value.
The Benefits of Using 401(k) Advisors
Retirement is definitely not a “set-it-and-forget-it” investment. In fact, you could be leaving a lot of money on the table if you simply let your 401(k) sit. Some funds, over the years, may perform better or worse than expected and changes in the market can happen rapidly. If you want to maximize your return, being active and keeping an eye on your account is essential.
Financial planners and 401(k) advisors can step in to help you. These experts can recommend what funds to consider investing in, answer any questions you might have, and consult with you on future investment opportunities for growing your retirement savings. Even if you’ve just opened your 401(k) and have other accounts like an IRA, they can still offer helpful advice.
The rise of fintech apps have made retirement savings and investment more accessible to anyone looking to save. These apps can offer some tips on trading and investing, but it should be noted these apps aren’t the same as a financial advisor. Any investment you make naturally comes with risk, so getting the advice of an expert before making any move is a wise decision.
Getting Your First 401(k):Frequently Asked Questions
A: Yes, you can. However, an experienced advisor can offer you advice and strategies to maximize your returns.
A: You can open a 401(k) through your employer or open an IRA through a provider. Some of these providers, it should be noted, charge fees or commissions.
A: There are a lot of options for managing retirement funds. If you like being involved, you can try to manage your account yourself. “Robo-advisors” can provide help with automatic allocation, while a financial advisor can manage your account and share new strategies for investing.
A: Not quite. While it’s also a workplace-sponsored retirement plan, a 403(b) is mostly used at particular tax-exempt organizations and the public sector. There are pros and cons to a 403(b) in comparison to a 401(k), including vesting time and protection.
Saving for retirement can be scary, but it certainly doesn’t have to be! Opening your 401(k) and contributing to it regularly are two great first steps to prepare for your retirement. But retirement savings aren’t something you should set up and then leave to gather dust.
If you don’t know where to start with your 401(k), or if you want to kick your savings into high gear, a financial advisor can guide you onto the right path to retirement. At 401karat, we combine expertise with technology to help you make data-driven decisions for your 401(k) to help you maximize your returns. For just $50, you can get started and start saving more.