Breaking Down Your 401(k): 6 Things You Should Know
I have gotten a lot of questions about 401(k)s lately, so I thought this would be a good time to discuss this in human terms, not in HR terms.
As a Millennial, it is important to understand how 401(k)s work and how they can be beneficial for you in the workplace.
What is a 401(k)?
A 401(k) is a type of retirement plan that employers offer. There is a high probability that your company offers a 401(k) to you and your coworkers.
Many companies automatically enroll you in this plan at a 3 percent contribution rate.
This means 3 percent of your pre-taxed paycheck will go directly into the 401(k).
You are allowed to contribute as much as $18,000/year, so you can change your contribution rate to whatever you feel comfortable with.
Example: Let’s say you make $36,000/year before taxes and you get paid once per month. This means each pre-taxed paycheck would be $3,000.
If you start contributing 3 percent into your 401(k), $90 will be contributed from every paycheck.
Many companies will also offer some sort of match to your contributions up to a certain amount.
The employer match is what makes this the best available retirement plan on the market.
What are the benefits?
You are saving money. This is by far the simplest way for anyone to save money without ever seeing the money in the first place.
This will keep the money from ever touching the bank account, which will keep you from hitting up happy hour.
If you aren’t contributing enough for your company to give you the maximum match, you are literally letting your company keep money from you.
I have made this mistake at big companies with BIG matches, and it still haunts me at night.
I’m so young and isn’t retirement so far?
“I’m only in my 20s, I’ll start contributing when I am closer to retirement.” If you want to be poor, please listen to this person’s advice.
Aside from the good looks and the fast metabolisms of people in their 20s, another advantage we have on our side is time. The younger we start investing and saving for retirement, the more time we will have to accumulate wealth.
Let’s take the salary and contribution example from above.
Let’s say the person making $36,000/year is 25 and he or she continues to make a 3 percent contribution per year for the next 40 years while the salary never increases and while the employer never matches.
According to the CNN’s Savings Interest Calculator, if the person averages 6 percent growth per year, by the time retirement roles around at 65 (yeah right), the balance in the 401(k) will be $179,234!
Remember, this doesn’t even include a salary increase, contribution increase or an employer match.
Chances are, this person would be a millionaire if all of that were put into effect.
Taxes?
Since contributions to your 401(k) are made before taxes are taken out of your paycheck, you must pay taxes on the money once you start withdrawing from it during retirement.
The good thing about this scenario is, since the company is pulling the funds out before taxes hit, it means your income will be smaller so you will pay less in taxes.
This makes contributions easier on your paycheck.
What are my investment options?
Your employer will give you a small list of investment funds to choose from.
Ask your HR department, or designated 401(k) department, to provide you with descriptions of these funds and do some research.
The younger you are, the more stock you should have in your portfolio, as you can take bigger risks.
As you get closer to retirement, it is normal for a portfolio to have more fixed income funds (bonds and CDs) than stocks, as one cannot take as much risk.
There are people at your company, or a third party, available to help you choose funds according to your age. Use these people, or find a financial advisor friend who would be willing to help educate you.
Do what you feel comfortable with, but do not be afraid of getting your funds invested.
If you are afraid of losing your money and don’t feel comfortable investing just yet, start by investing a small portion and ease into it.
You can typically change the investment options at anytime.
What if I want to quit my job?
What if I quit my job? You have four options:
- Leave your 401(k) at your previous employer (if you meet the balance requirements).
- You can take a full distribution (withdraw all funds, which will be fully taxed and you will get hit with a 10 percent penalty if you are younger than 59 and a half). Don’t do this unless you are in DESPERATE need of this money.
- Move the funds to your new employer’s retirement plan (if they allow it).
- Do a “rollover” into a traditional retirement account. This means opening an IRA either online, a brokerage firm or a bank, and transferring the 401(k) funds into that account.
What you choose to do depends on the balance of the account; investment options available through the different outlets and your individual needs.
It is also important to know the “vesting” date of your plan.
You don’t want your employer taking away what he or she gave you because you didn’t stay with the company long enough.
Not all companies have this, but even though I am all for quitting jobs you hate and doing things you love, this would be something to look into.
401(k)s give many employees the access to save money for retirement, while typically providing a low-fee structure and most importantly, matched contributions by employers.
It’s important for all 20-somethings to make sure they are educated about what their companies offer and how they can get enrolled right away to start receiving all possible benefits.
If you’re going to work for the “man,” take advantage of the “FREE” money!
