You’ve recently graduated and just landed a career. For many of you, 401(k)’s and other retirement planning terms is a bunch of jargon. Don’t worry, you didn’t have someone to guide you through the process and you’ve just begun. The earlier you start planning for your retirement, the more prepared you will be. Today, the chances of people living to 100 is quite common but no one really prepared themselves to live that long. Without proper planning, your retirement won’t be what you envisioned. You may have to work longer than expected at jobs you don’t want to do or struggle financially that prevent you from doing things you really wanted like travel. One of the ways to start building your portfolio is by taking advantage of the 401(k) provided by your company.
What is a 401(k)?
A 401(k) plan is a retirement savings plan that is sponsored by an employer and legally offered to employees. When money is entered into the employee’s 401(k) retirement account by either the employer or the employee, they receive a tax deduction on their investment. When 401(k) plans first started in 1978, people invested money into their accounts pre-tax.
Pre-Tax 401(k) Contributions
Usually when a person earns money, they have to pay income taxes on what they earned. However, a 401(k) plan allows you to avoid paying income taxes in the current year on the amount of money (up to the legal allowable 401(k) contribution limit) that you invested into your retirement plan. The amount invested into the plan is called a safety deferral contribution because you are deferring some of your income that you earn today into your 401(k), and saving it so that you will have money during your golden years.
The money that you invest grows tax-deferred inside the plan. What this means is that as your original investment earns additional investment income, you do not have to pay taxes on the investment gains each year.
Instead, when you are retired, you pay tax on the amounts you withdraw from your 401(k). There is a 10% penalty tax and income taxes if you withdraw from your account before you reach either 55 or 59 ½ depending on the rules of your 401(k) plan and the age at which you retire.
Roth 401(k) Contributions (After-Tax)
An alternative to the traditional pre-tax 401(k) contributions, is the Roth 401(k) contributions which many employers offer as an option. If you decide to go with this option instead, you do not get to reduce your earned income by the contribution amount. However, the money that you invest grows tax-free, and withdrawals that you take out during retirement are also tax free!
Pre-Tax Contributions vs. After-Tax Contributions
Now you have to decide whether you to pre-tax or after-tax contributions. As a general rule of thumb, you want to make pre-tax contributions during years that you earn a higher income. This typically occurs during the middle and late stages of your career. On the other hand, you want to make Roth contributions during years where your earnings (and thus tax rate) are not as high. This normally occurs during the beginning stages of your career or at any point of your career that you are working part-time.
Many employers will make contributions to your 401(k) plan for you. There are three main types of employer contributions: matching, non-elective, and profit sharing. Employer contributions are always pre-tax, which means these contributions will be taxable when they are withdrawn in retirement.
Matching vs Non-Elective vs Profit Sharing
Matching contributions are when your employer puts money into your 401(k) plan after you put money in yourself. For example, they may match your contributions dollar-for-dollar up to the first 3 percent of your pay, then 50 cents on the dollar up to the next 2 percent of your pay.
Non-elective contributions are when your employer has a set percentage that they put into the plan for all of their employees regardless of whether the employee is contributing any of their own money or not. For example, the employer usually contributes anywhere from 3% to 6% of pay to the plan each year for all eligible employees.
Profit Sharing Contributions is when a company makes a profit, and puts a set dollar amount into their employee’s 401(k) plans. There are multiple formulas that companies use in order to determine how much money is contributed to each employee. The most common formula is when each employee receives a profit sharing contribution that is directly proportional to their specific pay.
Opening up a 401(k) account with your company at the start of your career is very important in order to become more financially stable during retirement. If you start planning at a young age, time is on your side, and the money that you save today has decades to grow. With a 401(k), investments compound over time, which means that you earn interest on money that you originally deposited, and you earn interest on your interest. That’s why it is highly recommended to get a 401(k) plan as early as you can so that you can let your money grow for as long as possible!
Toolkit to help you:
- BankRate 401K Calculator
- Blooom 401K Calculator
- NerdWallet 401K Calculator
- SmartAsset 401K Calculator
Videos to help you:
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