As promised, we are kicking off a personal finance series into tax-advantages savings plans. If you missed the post all about the wonders of compound interest and why you should start saving for retirement right this very second, click here. First on our list of tax-advantaged savings options are employer-sponsored retirement plans, also known as a 401(k).
What is a 401(k)?
A 401(k) is a retirement savings plan offered by most employers. The most important thing to note about 401(k) plans is that any contribution you make (a percentage of your pre-tax salary) is contributed by your employer directly to the account, before any tax is taken out. So if you make $50,000 a year and decide to contribute 20% of your annual pre-tax salary to your 401(k), you will only be taxed on $40,000 of income. Depending on how high your income is, this could make a significant difference in how much you are taxed on your remaining income.
What are the advantages of saving with a 401(k)?
The intention of a 401(k) is to continually save over the course of your life, benefiting from pre-tax contributions, the wonders of compound interest as well as a delayed tax bill. While you will eventually be taxed when you take the money out of the account after retirement, you will likely be in a lower tax bracket and will likely pay less tax on those withdrawals.
It is worth noting that 401(k) accounts are investment accounts and are therefore subject to the same risks of any investment account. Over the history of the stock market, the average rate of return has been about 8%. Although it could go up 20% one year and drop 10% the next year (or vice versa), you are playing the long game. Don’t get too wrapped up in swings and roundabouts. If you compare that average annual return (8%) with the interest rate available in taxable savings accounts (usually less than 1%), there is a clear advantage to saving in your 401(k) from both a taxation and return perspective.
What are the disadvantages of saving with a 401(k)?
The major disadvantage of a 401(k) is that the money is not easily accessible. It should not be considered an emergency fund. You can’t withdraw money (without penalty) before you are 59.5 years old.
Because your 401(k) is an investment account, there is some degree of risk. If your investments are doing well and growing, your account with grow. If your investments are doing poorly, your account will take a hit and you can lose money. You can mitigate this risk through diversification and choosing your investments wisely, but you could still lose money. As a general rule of thumb, the closer you get to retirement, the lower your risk appetite should be. You will want to take a very risk-averse approach in order to ensure you have enough money saved for retirement.
How much money can I put in a 401(k)?
The maximum tax-free contribution you can make every year is $18,000. Most employers will allow you to adjust the percentage of your contribution throughout the year, meaning that you can contribute out of your base salary, bonus or a combination of both.
What if I want to take the money out before I am 60?
You can access the money without penalty once you turn 59.5 years old. Good lord. If you take money out prior to then, you are subject not only to income tax (at your current income tax bracket rate) but also there is a 10% penalty fee.
But you can borrow from your 401(k) in order to make a down payment on a house or other property. The loan can be up to $50,000 (or half the value of your account, whichever is the lesser amount). You do have to pay back the loan to your 401(k) in addition to making your monthly loan payments, but this is usually a cheaper option than withdrawing the amount necessary and suffering the 10% penalty fee.
What does it mean when an employer offers to “match”?
This is SO IMPORTANT. If your employer offers to match your 401(k) contribution, you have to take advantage. Matching = FREE MONEY. Some employers offer to match your 401(k) contribution up to a certain percentage. Some offer to match 50% of your contribution up to a different percentage. Others cap their contribution at an actual dollar amount. Find out what your employer offers, if anything, because free money is free money.
As an example – if you make $50,000 a year and contribute 10% of your income ($5,000 of your pre-tax income) to the 401(k) and your employer matches up to 5% dollar-for-dollar, your employer is essentially giving you $2500 of free money every year.
Whatever you do, make sure you max out that percentage that they offer to match. If they offer to match up to 2%, you should be contributing 2% AT THE VERY LEAST. If they offer to match up to 7.5%, you should be contributing 7.5% – even if you have high interest debt that you are paying down. Take the free money – all the time, every time.
What if I change employers?
Easy peasy – you can move your 401(k) from one employer to the next (if they use the same financial institution) or you can roll it over into an IRA – which gives you more investment options and greater control over your risk profile than most 401(k) allow. It is a fairly painless process and allows you to continue saving in the same account no matter how many times you switch jobs.
Sincerely yours in harmonious fun and fiscal responsibility,