401k Basics: The Questions You're Afraid to Ask
It seems as though people in the money industry thrive on confusion. But today, we want to cut through some of the sludge and talk about 401k basics.
You know you should be saving for retirement, you’ve heard it 1,000 times. But are you ready to contribute to a 401k? Let’s do a brief check to see if it’s a good idea based on your current financial situation.
Should I Start Saving for Retirement?
Can you check the boxes on the following five statements? If you can, you’re ready to begin investing for retirement. You:
- Can cover your monthly expenses and needs
- Have a budget and know where your money is going
- Don’t live paycheck to paycheck
- Have a emergency fund set aside ($1k minimum)
- Don’t have any high-interest debt (this could be credit card debt or any loans with a 10-15% interest rate or higher)
Once you have these five steps down that focus on providing your here-and-now financial stability, then you can begin thinking about your future financial stability with retirement savings.
Still working on that list? YNAB can help you get on top of your money and know exactly where it’s going. Start your free trial today (no credit card required).
Why Shouldn’t I Save For Retirement If I Have Credit Card Debt?
It’s downright admirable to want to invest for retirement early, but if you have high-interest debt, it’s probably not the wisest financial decision for you.
For example, suppose you have a $3,000 balance on a credit card with an interest rate of 19%. You’re anxious to begin putting some money away so you start a retirement fund that could potentially earn 9-10% per year. If you would simply pay off your credit card balance you would, in effect, be making a guaranteed return of 19%! Completing the first five steps mentioned above keeps the most money in your pocket and gives you the most stability.
401k Basics: Do You Have an Employer Match?
Once you’re ready to start investing for retirement, you should first look at your company’s 401k plan to see if they offer an employer match. The reasoning behind this is pretty straightforward. If you work for a company that matches 2 to 1, then that would mean that for every $1 you contribute into your 401k, your employer contributes $.50, usually up to a certain percentage cap of your salary. This is as close to free money that you’ll get in this world!
Skipping out on employer-matched 401k contributions is like flushing money down the toilet. Holding all other things constant, if your employer matches your contribution, then you are making a return of 50% on your investment. That’s not too shabby, partner.
How Does a 401K Work?
You’ll determine a percentage of your salary or a set amount you want to contribute each paycheck into your 401k, and this is typically done in onboarding paperwork. In general, payments get auto-deducted from your paycheck. This is advantageous to pretty much all of us—it takes us out of the equation. It’s also pretty darn convenient—you don’t even have to think about it!
Your 401k contribution, along with your employer’s matching contribution, will be put into your 401k amount. You’ll want to make sure this money is then being invested in some type of long-term investment fund—a mutual fund, index fund, or target-date fund. You’ll pick the funds you want, and your contributions will be invested in those options accordingly.
Generally with a 401k plan you’ll be given several fund choices, and diversification can happen fairly easily with these options. Personally, I like index funds for their ease of administration and low expenses, and also target-date funds for their simplicity and convenience. Make sure to choose a fund with a risk profile you feel comfortable with. If your allocation doesn’t allow you to sleep at night then it’s probably not worth it to you. Understand what you’re investing in and keep it simple.
Some companies allow you to invest in company stock, even at a discount. But do be wary of putting too many of your eggs in one basket. It’s always a good idea to diversify.
Are There Limits to 401k Contributions?
There are limits to how much you can invest in your 401k. In 2022 the IRS has capped the contribution limit to $20,500, or about $1,708 per month if you’re maxing it out.
If you’re over the age of 50 and need to move quickly in planning for retirement then the 401k is still a great vehicle. Current legislation allows anyone 50 years of age or older to contribute additional funds. Many plans offer these catch-up contributions, but check with your employer first to make sure.
For complex financial situations or managing an ever-growing retirement portfolio, it can be a good idea to talk with a financial advisor to get a gut check on your portfolio or help with your retirement planning.
Are There Tax Benefits to a 401k?
The tax breaks of a 401k are powerful and in your favor as long as you play your cards right. Generally, contributions to your 401k are made pre-tax, which saves you money on your income taxes.
Another tax advantage to the 401k is that all of your earnings from your investment are tax deferred. That means you’re not taxed when the money goes in (during your illustrious and hypothetically high-earning years), but when you need the money in retirement, you could be paying taxes on withdrawals at a lower tax rate than you’re at today. The 401k is a powerful vehicle to minimize your tax bill while maximizing your return on investment.
Can I Use 401K Money Before Retirement?
Be warned: if you contribute to 401k, it is there for retirement. The IRS imposes a 10% early withdrawal penalty if you’re under age 59 1/2 which can be absolutely devastating to your growing nest egg. That means if you were withdrawing funds of $10,000 when you’re 35, you’d fork over $1,000, plus additional taxes you’d have to pay on earnings. You might be taking home as low as $7,000 out of your original withdrawal. Avoid withdrawing your 401k if you can at all help it.
What Happens to My 401K if I Switch Jobs?
If you change jobs, start your own business, or are laid off, there are a few options available to you regarding your 401k:
- Take a cash disbursement. This is the absolute worst choice and it’s full of automatic withholdings, penalties, and you’ll have to pay taxes.
- Leave the investment with your employer. This choice is much better than the first. If you choose to leave it with an employer it continues to grow tax-deferred, but you do want to remember it’s there (and not forget about it!). Many people find it complex and hard to manage multiple accounts spread over multiple employer retirement accounts.
- Transfer your 401k to your new employer. This is a solid choice. You end up having your investment under one administrator, which makes it easier to manage and monitor. Not every employer allows you to do this, which might make the last option your best choice.
- Rollover the 401k to an individual retirement account (IRA). This option is a great choice for a couple different reasons. First, you can always rollover your 401k account and don’t have to worry about whether your employer accepts transferred 401k plans. Second, a traditional IRA offers all of the tax advantages of a 401k plus increased flexibility. You can invest in almost anything you want with an IRA, while a 401k’s choices are limited by the employer plan options and plan administrator (usually 10-15 different funds).
401k Basics: Know Your Vesting Schedule
One other important term you might want to be familiar with is vesting. Most companies have certain requirements regarding when the contribution they make on your behalf actually becomes your money. You may have to work a certain number of years before the employer contributions are vested. Being vested simply means that those funds now belong to you and you can do with them as you please.
If your company’s vesting requirement is three years, and they’ve matched your contributions at all, it would be a good idea to stick it out if you’re thinking of quitting with two years and eight months left. You could be leaving a lot of money on the table! Not only would you be letting go of the amount contributed, you’d also be letting go of any capital gains attributed to that amount and any future capital gains that amount would have earned for you.
401k Basics: Closing Thoughts
The 401k is there for your use. It’s a powerful, tax-advantaged tool when used correctly and should belong in your arsenal of retirement savings weapons along with something like an HSA and Roth IRA. Hopefully this 401k basics discussion has helped you. Use it wisely.