Time and tide wait for none. What also does not wait is money. The reality of the American dream could hit you hard when you reach your retirement time. As a result, people fall for ignorant retirement mistakes leading to big problems. Especially, when there are bills to pay for a myriad of things, from electricity bills to the medical bills (trust me; no one will be perfectly healthy by that time with the way our lifestyle is going). So, you have to stress not only about your present but also your future. That is where 401(k) comes in.
As the cost of providing pensions have surmounted, the employers are replacing them with the 401(k) Retirement plan. A feasible retirement plan will help you remain monetarily stable and help you continue living your life. After all, little drops make the ocean. How is it different from other old-world investment and pension plans?
An introduction to 401(k):
A 401(k)-retirement plan is a defined-contribution plan. It is a plan in which employees can invest pre-tax dollars, the money before tax is deducted, in the capital markets. Further, the money they have invested gets mature in a tax-deferred way until the time of withdrawal, which is retirement in this case.
It is a type of retirement savings plan which is mainly provided by the employers. Here, you can save money from your salary before the tax is deducted. By contrast, a pension plan is a defined-benefit plan. In this plan, the responsibility of saving money is on the employer alone after the retirement of the employee.
The employers apart from sponsoring 401(k) may give a matching contribution to add to your savings. Then your tax is deducted, from the remaining amount of salary.
Thus, this helps reduce the amount of tax you pay. You do not have to pay tax for your investment until the time of withdrawal, which is only at the time of your retirement. Otherwise, you have to pay a tax penalty.
Guidelines for 401(k):
Created by Congress in 1981, this retirement plan is used by most of the workforce now. Its name comes from section 401(k) of the Internal Revenue Code (IRC). Since 401(k) is a qualified-retirement plan coming along with special tax benefits under the guidelines of IRC, it has many limitations and caveats.
According to the guidelines, your maximum-contribution limit is defined. An earlier trend noticed in 401(k)is that from 2010 due to inflation, the limit has been increased periodically. From this, the obvious can be stated- the earlier, the better. This is because your money will be compounded and you could end up with thousands, maybe even with, millions of dollars after investing.
There are two varieties of 401(k)- Traditional 401(k) and Roth 401(k). They mainly differ on the grounds of tax rules and withdrawal rules.
The traditional 401(k) uses pre-tax money to invest; therefore the amount of tax you pay reduces depending on how much you contribute. Then at the time of withdrawal, you pay your income taxes on the contributions and earnings you received. The catch is that you are not allowed to withdraw until you are the age of 59 ½ or you have left your employer at 55 years or older. If you try to withdraw earlier than that, then you have to chip in a 10% penalty apart from your usual tax bill.
The Roth 401(k) variation is now trending more. Here, the employee makes contributions from the money that has been already taxed. On withdrawal, no taxes are required for your contributions or investment earnings. There is also better flexibility as you can access your money freely after you hold the account for 5 years.
Benefits of employer’s matching contributions:
The main advantage of an employer’s matching contribution is that it is not included in the maximum-contribution limit. So even if you reach your limit, the employer’s match is added over that limit, giving you more earnings.
The catch is that you can open your 401(k) account, but most of the companies do not start off contributing from their side immediately- they take up to a year to do so. This is to avoid employees (especially young) leaving early.
With that being said, how much do you put in once the company also starts contributing? To avoid leaving free cash around, it is highly advisable to invest a full amount that your company agrees to match (the most popular matching funds are 3% of your salary) while ensuring you have enough to manage your current debts. Do not forget the tax-deferred gains from 401(k) that can reduce your current tax amount when you contribute more!
Advantages and disadvantages:
Advantages: A plethora of customizable investment options are available which are mutual funds in most of the cases, managed commonly by financial services advisory groups.
A rollover option is allowed that will provide you with more investing options. A rollover happens when you directly or indirectly transfer your money from traditional 401(k) plans (here limited investment choices are only available) to a Roth 401(k) or a Traditional IRA (Individual Retirement Account) plans.
Then there are the aforementioned tax advantages and employer match programs. One can also move the account from one employer to another. You can also obtain a loan from your 401(k) account.
Disadvantages: The 401(k) loans can disrupt the dollar-cost averaging process that can decrease your long-term results. Apart from paying interest, even though you are borrowing your own money, defaulting leads to the payment of penalty fees.
The money cannot be withdrawn until you are 59 ½ in the case of traditional 401(k) plans or early hardship withdrawals are subjected to a 10% penalty apart from taxes.
The 10% penalty is rejected only in five different cases. It includes being completely disabled; leave job after turning 55 or the court of law has ordered you to give funds to a dependent.
Nowadays, a 401(k) Retirement plan is an inevitable option. You must read through the complete guidelines before investing in any plans. So that you can assess your benefits beforehand and live a peaceful after-retirement life the way you want.