September 10 is National 401 (k) Day
If you’ve just started a new job and are considering the 401 (k) option, you’re probably wondering how it works. Your golden years depend on the investment choices you make today. And if you rely on your 401 (k) to play a significant role in your financial situation, getting your questions answered is important.
What is a 401 (k) plan?
A 401 (k) is an employer sponsored retirement savings plan. It allows employees to benefit from retirement savings deducted from their pre-tax salary. If your workplace offers a 401 (k), you will complete a registration package containing information about the acquisition, beneficiaries, and investment options.
How many types of 401 (k) are there?
There are two basic types of 401 (k): traditional and Roth. Both are employer sponsored retirement savings plans, but they are taxed in different ways.
A traditional 401 (k) offers upstream tax benefits. Your money comes in tax-free, but you pay taxes on the employer match (if you have one) and any withdrawals you make in retirement, which includes any growth in your contributions.
A Roth 401 (k) offers tax-exempt growth. Your contributions are taxed upfront with after-tax dollars, but you don’t pay tax on your contributions or their growth when you retire. You will still have to pay taxes on employer contributions.
There are a few other types of 401 (k) available for the self-employed or small business owners:
• Solo 401 (k): Also known as the one-participant 401 (k), the 401 (k) solo was created for business owners who work for themselves and have no employees. It allows you to contribute both as an employee and as an employer.
• SINGLE 401 (k): If you are a small business owner with no more than 100 employees, the SIMPLE 401 (k) is for you (it is very similar to a SIMPLE IRA). As an employer with this plan, you must offer an equivalent contribution up to 3% of each employee’s salary or pay 2% of each employee’s salary (even if they do not make contributions).
How Much Should You Invest in Your 401 (k)?
If your employer offers a match, you should at least invest enough to take full advantage of this benefit. Most companies (86%) with a 401 (k) plan offer a match on employee contributions. The employer’s average match is around 4.5% of your salary. Even if your employer matches less, that extra money can make a big difference over time in your nest egg.
After enjoying the game, so what? Overall, we recommend that you save 15% of your income for retirement. Does all of this have to be in your 401 (k)? Not necessarily. Here are some options:
• Option 1: You have a Roth 401 (k) with great mutual fund choices. You can invest your entire 15% in your Roth 401 (k) if you like the investment options in your plan.
• Option 2: You have a traditional 401 (k). Invest until the match, then put your remaining 15% into a Roth IRA. If you contribute the most to a Roth IRA and you still have money left over, you can go back to your traditional 401 (k).
What is the current contribution limit for your 401 (k)?
The annual contribution limit for a 401 (k) in 2021 is $ 19,500. If you are 50 or older, you can make catch-up contributions, increasing your annual limit to $ 26,000.
What should your 401 (k) be invested in?
We recommend that you diversify your portfolio by including an equal percentage of funds from four different mutual fund families: Growth, Growth and Income, Aggressive Growth, and International. Work with your financial advisor to choose mutual funds with a long history of above-average performance.
When to invest in your 401 (k)?
Don’t start investing until you are in debt (everything except your mortgage) and have a fully funded emergency fund with three to six months of spending. If you’re investing now, but still have debt on top of your mortgage, it’s time to hit the pause button. Temporarily stop putting money into your 401 (k) and focus on these two steps first.
Your income is your best wealth building tool. If your income is tied to paying off your debts, you are depriving yourself of a chance to build wealth. Debt equals risk, so get it out of your life as fast as you can.
If you start investing without having set up an emergency fund, where do you think you might look for money when the air conditioner in your house turns off? That’s right, your 401 (k). If you take money out of your 401 (k), you’re not only jeopardizing your retirement future. You will also be affected by taxes and early withdrawal penalties. This is why it is so important to have an emergency fund with 3-6 months of expenses.
What is the impact of fees on your investment?
It is important to understand the totality of how fees affect your investment portfolio. Your 401 (k) might seem like an expensive way to invest, but if you get a business return on your contributions, the payoff is almost always worth it.
If you choose funds based on fees only, you are missing an important part of the picture. While some funds may look attractive because they offer low fees, it’s worth taking a second look to make sure you’re not sacrificing performance. You are looking for a combination of low fees and high returns.
What does it mean to be invested?
Earned is a term used to refer to how much of your 401 (k) is yours if you quit your job. The money you contribute is yours, but some employers have guidelines on how much of their matching contribution you can take with you.
For example: if your business increases the amount you are invested by 25% each year, quitting your job after two years would mean you could only take away 50% of employer contributions. Once you are fully vested, you keep 100% of employer contributions.
What happens to your 401 (k) when you quit your job?
You basically have four options when you quit your job: do nothing and leave the money in your old 401 (k), transfer it to an IRA, transfer it to your new employer’s 401 (k) plan, or cash out your 401 (k). (k)).
Do not cash your 401 (k) plan.
When you withdraw your 401 (k), you don’t keep all the money. You will owe taxes on the total amount, as well as a 10% withdrawal penalty. Your best option is to transfer your 401 (k) funds to an IRA, as this gives you the most control over your investments and which mutual funds to choose from.
What are the rules for 401 (k) withdrawals and 401 (k) loans?
When life arrives, it’s easy to look to the savings you’ve built up in your 401 (k). The money is right there, isn’t it? It turns out that withdrawing money from your 401 (k) early is a bit of a hassle.
According to the IRS, you cannot withdraw money from your 401 (k) until you are 59 and a half without paying income tax and a 10% early withdrawal penalty. . But there is a “loophole”: 401 (k) loans allow you to use your retirement savings without paying penalties or taxes if you pay back the money. Of course, doing that comes with a bunch of rules, and things can go wrong quickly.
Here’s why 401 (k) loans are a bad idea:
- You must repay the amount you withdraw with interest.
- Your investments in your 401 (k) at work account are pre-tax, but you will repay the loan with after-tax dollars. This means that it will take longer to accumulate the same amount. You will have to pay additional taxes and penalties if you do not pay off the loan within a certain time.
If you quit your job, for any reason, and still have an unpaid 401 (k) loan balance, you must pay it off in full by the tax filing deadline the following year, including any extensions. (thanks to the Jobs and Tax Reductions Act of 2017). Under the old law, you had 60 to 90 days to pay off the balance in full.
Should you work with a financial advisor?
You need the experience and knowledge of a financial advisor or investment professional to help you make informed decisions about your investments. Work with a real professional – one with the heart of a teacher – to create a long-term strategy for your investments. You want a pro who is smarter than you, but who understands that you are in charge.
Provided by and used with permission from Ramsey Solutions