A 401(k) is a retirement account that is sponsored by your employer. Savings accumulate in the account through employee funding which comes directly from your paycheck! Here are some of the advantages of a 401(k).
Matching Contributions: Many employers will match a portion of your savings. It’s like passing up free money if you don’t participate! A common match might be 50% of the first 6% of pay you save.
Tax-Deferred Earnings: When you contribute a percentage of your pay to a 401(k), you immediately start paying less taxes. That’s because your contribution comes out of your paycheck before income taxes are deducted. That means your taxable income is less, lowering your tax bill! This means you defer or postpone paying income tax on your tax bill until you withdraw money at retirement. For many people, their income is lower at retirement, so they are paying a smaller amount of tax on the money!
Loans: Many plans allow you to borrow from your account for specific reasons, such as buying a primary residence, paying for education or medical expenses, or in case of severe economic hardship. A loan usually must be paid back with interest within five years and as long as you remain employed by the company, you can pay it back without incurring any income tax liability. The interest you pay goes directly into your account.
If you leave the company, you will be required to pay back the entire loan within 30 days or face paying income tax on the unpaid loan amount as well as 10% early distribution penalty if you're under the age of 59 ½.
Most 401(k) plans provide a variety of investment vehicles for you to choose from. This typically includes things such as:
Money market funds
Stocks and bonds
Your employer's stock
Each type of investment offers varying risk and reward, so we always recommend understanding your risk tolerance, which can depend on your age and place in life. For example, money market funds have very low risk, since they’re often invested in certificates of deposit; however their earnings potential is much lower than other types of investments and they don’t always keep up with inflation. Stock and bonds have higher risk for loss of value, but they also have more potential to earn more, especially over long periods of time.
Typically, you can mix and match your account balance among the different options available. Check your plan documents to see if there are any restrictions on when or how often you can request changes. With many plans, these kinds of changes can be done online.
The sooner you start saving for retirement, the faster your account will grow.
Here's an example: Say you contributed $5,000 a year to a 401(k) for 10 years - assume that your investment earned 8 percent a year and all investment earnings were reinvested in your account. Depending on how old you were when you made those contributions, you would see wildly different amounts at age 65 when you retire:
If you started saving at age 25, stopping at age 35, when you retire at 65 your account would be worth about $787,000.
If you started saving at age 35, stopping at age 45, it would be worth about $364,000.
If you started at age 45 and stopped at age 55, its value would be only about $170,000.
And, if you waited to start saving until age 55 and contributed until age 65, you'd only amass about $78,000.
These examples assume that you only invest $5,000 a year for 10 years and then stop. These estimates don’t even factor in employer-matching contributions, which could make your account grow even larger and faster.
If you have the ability to invest in a 401(k) we hope that this article inspires you to do so.