So, you’ve got a job, now what: Your 401(k) explained.
Congratulations! You’re employed!
Now, the next big hurdle that you must traverse is saving for retirement. Let’s be realistic, this is a big reason that you went to work in the first place. Sure, it’s important to have an income and support yourself, but at some point, you won’t be able to do that yourself and you need to save for that time. You also won’t want to work forever either, so now is the time to be saving as much as you can for retirement. Thank goodness, the government invented something called the 401(k) for you. This little invention gets its name from the subsection of the IRS tax code that makes it legal.
The 401(k) is a tax advantaged retirement savings plan that incents employees to save for retirement. It acts as a tax-free box for your investments so that you won’t have to rely entirely on social security for retirement income. This is also one way that employers can compete for labor without just offering a larger salary. The 401(k), along with the other retirement savings plans that may be offered by your employer, are essential to providing for your future. Let’s get into how they work so you can make the right choices when investing with yours.
So, there are a few of these “tax advantaged retirement accounts” out there. The 403(b) is the public education and nonprofit employee version of the 401(k). There are also Thrift Savings Plans, usually referred to as TSPs, that are offered to Federal employees. The employee usually becomes eligible for these plans after working at the company for a few months. After you become eligible, you get to decide what percentage of your pre-tax paycheck gets contributed to your 401(k). That’s the beauty of the plan, it’s all pre-tax income. Your company will then invest this money on your behalf. Your company becomes what is called “the plan sponsor”.
Usually what happens next is your company will pay another company (either an insurance company, mutual fund provider, or a brokerage firm) to manage the investment account on their behalf. Then, your company will send over the percentage of your pre-tax paycheck that you decided on to the managing company and the managing company will execute on the purchase of your investments. Most financial experts say that at least 10% of your paycheck is a good start. Usually, the company that employs you will also match your contribution up to a certain percentage of your paycheck. This is basically free, untaxed, money that you should take advantage of as often as possible. Then, as your 401(k) grows, all the dividends and capital gains that may accumulate are tax free.
Now, you’ve been working and saving for a long time. When do you get to take this retirement money out? Despite a provision that I’ll talk about in a second, your first opportunity to get at the money without a penalty is when you turn 59 and a half years old. If you take money out of the 401(k) before then, you will incur a 10% “early withdraw” fee. Now, there is something called the “55 provision” where you can take money out of the 401(k) early if you leave the company that offered you the 401(k) after age 55 but before 59.5. When you start to take money out of your 401(k), it is treated as income and so you are taxed at your income tax bracket. This is okay though because usually when you retire your tax bracket drops significantly because you won’t be making a salary at that point. Many investment advisors will ask if you would like to factor in social security when you go to retire because many are not sure if the social program will be around by the time our generation retires. The 401(k) is one way of hedging your bets and protecting your future.
There are some other things to be aware of as well. When you leave the company that offered you the 401(k), you can opt to rollover the 401(k) into an Individual Retirement Account or IRA. The IRA has a few different implications than the 401(k), but it’s a lot better to rollover the 401(k) than maintain a myriad of 401(k)s as you switch from company to company. You will also lose the 55 provision if you convert to an IRA, so make sure to think long and hard before you do so. 401(k)s are also creditor protected, so you probably shouldn’t try to pay off debt with that money. You will be charged the “early withdrawal” fee and probably for no tangible economic reason.
Putting money into your 401(k) is often uncomfortable for people who have just started working because it means that you will have less money to spend today, but if you want to make sure that 55-year-old you has a good shot at retirement, it’s so important for you to start putting in money today.
The way investing works dictates that time is the best indicator of growth, not the amount of money that you put into an investment. Every dollar you invest today will return much more money than any dollars that you invest after today. This is because of the time value of money and the power of compounding interest.
Most companies have some financial advisors on staff so consult them if you get the chance and if that’s not an option make sure to consult a traditional investment advisor. Enjoy the new job and all the goodies that come with it!
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Boyte-White, C. (2016, July 8). How a 401(k) Works After Retirement. Retrieved from Investopedia: http://www.investopedia.com/articles/personal-finance/111615/how-401k-works-after-retirement.asp
CNN Money. (2016, December 1). How does a 401(k) plan work? Retrieved from CNN Money: http://money.cnn.com/retirement/guide/401k_401kplans.moneymag/
McKay, B. &. (2011, July 19). A Young Man’s Guide t Understanding Retirement Accounts: The 401(k). Retrieved from The Art of Manliness: http://www.artofmanliness.com/2011/07/19/a-young-mans-guide-to-understanding-retirement-accounts-the-401k/
Practical Money Skills for Life. (2016, December 1). What is a 401(k) plan? Retrieved from http://www.practicalmoneyskills.com/personalfinance/lifeevents/benefits/401k.php