What is a 401K?

Of course you’ve heard of a 401k, but what exactly is it, and how do you manage one successfully?  401k plans are an excellent addition to your retirement planning and serve as a dual-feeding investment between you and your employer.  And even though there is an equal monetary deposit between both you and your employer, there are other aspects of the 401k plan that may or may not bode well for your financial plan.  In the very least, we will break down the nuts and bolts behind the 401k and give you the tools you need to decide whether it is right for you.

First and foremost, what is a 401k, and how does it work?  401k plans are retirement savings plans sponsored by your employer.  It allows employees to invest and save a portion of their paycheck before taxes are deducted.  Taxes are then taken out once the money is removed from the account.  With a 401k, you decide how your money is invested.  Most plans offer a spread of mutual funds composed of stocks, bonds, and money market investments. The most popular option tends to be a combination of stocks and bonds, which gradually become more moderate as you reach retirement.

Next comes the question of how much you should invest.  If your employer is matching your timely investment percentage each paycheck it would benefit you greatly to keep your 401k contribution at a feasible amount.  Obviously, manage your finances and ensure that you have enough to live and enjoy life, but keep in mind that retirement planning is important.  If your employer is offering a 50-50 contribution you should take advantage of the plan; don’t leave cash on the table.  The most popular contribution is 3% of your salary.  So, if you earn $50,000 a year and contribute 3%, your personal contribution will be $1,500 and your company’s contribution will be $1,500.  Although you can contribute over 3%, your company cannot, and this is where the possible drawbacks begin.

The IRS mandates contribution limits for 401k accounts.  As noted, your company will not contribute over 3%, and the total dollar amount that can be contributed—including both your contributions and your employers’—cannot exceed 100% of your salary.  In most cases, you can’t tap into your employer’s contributions immediately.  There are complex rules about when you can withdraw your money and costly penalties for pulling funds out before retirement age.  This is why most employers hire investment administrators to oversee your account.  It is their job to inform you of updates about your plan and its performance, manage the paperwork and assist you with requests.  You can also go to your administrator’s web site or call their help center if you need further assistance.

The final question is which type of 401k you should invest in.  Most companies offer a traditional 401k, where the less common plan is a Roth 401k.

Traditional 401k:

  • Wages are contributed before taxes from each paycheck, like a deferred salary.
  • Taxable income drops by the amount you contribute.
  • You pay income taxes on contributions and earnings upon withdrawal.
  • No access to your funds before age 59 ½ or if you leave your employer at age 55 or older.
  • If you dip in early, expect a 10% penalty — on top of the usual tax bill.

Roth 401k:

  • Contributions are made with money that’s already been taxed.
  • No taxes paid upon withdrawal.
  • Better flexibility: free access to your money as long as you’ve held the account for 5 years.

As you can see, there are benefits and drawbacks to both 401k retirement plans.  It is essential to survey your finances and what types of savings plans are right for you.  401k plans are great because of the contributions made by your employer, and the flexibility of deciding how much you’d like to contribute.  Don’t hesitate to ask if you have any further questions or comments regarding 401k plans or financial management in general.


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