There is a lot of value and benefit to investing in a 401(k) retirement plan. It is a common and powerful vehicle to help you fuel your nest egg when you get to retirement age. You may be fortunate enough to work for a company offering a 401(k) or something similar, and as such, you should know the ins and outs for your own benefit.
So many simply ignore their work retirement plan. It can be confusing to understand, and if you are decades from retirement, a 401(k) may seem pointless right now. The reality is, even if you are working for a company that you do not intend to stay with long-term, investing in your retirement in some form or fashion is always a good idea. In fact, the sooner, the better.
What is a 401(k)
A 401(k) is a type of retirement plan which is offered by your employer if they choose to do so. If you are someone who is self-employed, you can do what is known as a solo 401(k) plan.
With a 401(k) plan, you are contributing a portion of your paycheck or income and putting it into a retirement account. The retirement account is then set up for growth over time, with a variety of savings and investment options being put to work. Common vehicles put to use by the 401(k) include bonds, stocks, money market funds, and more.
Tax Implications to Keep in Mind
There are tax implications you should understand when it comes to your 401(k) plan. When investing in a 401(k) retirement plan, you are tax advantaged. The tax advantaged state comes from investing with pre-tax dollars. This means that when you are taking money out of your paycheck to put into your 401(k), you are not paying any taxes on those dollars.
If you invest $100 of your paycheck into your 401(k), your taxable income is reduced by $100 and that full amount goes into the retirement account. With a 401(k), you are deferring the payment of tax on your contributions and your earnings until the future.
Any investment growth in your 401(k) also sees a tax deferment. The only time you begin to pay taxes is when you get to the age of retirement when you start to do withdrawals from the built-up contributions.
Benefits of a 401(k) Plan
Some benefits of a traditional 401(k) retirement plan include:
- The 401(k) plans get protection by the Employee Retirement Income Security Act of 1974 (ERISA). This federal law sets standards employers must follow, as well as administrators of the plans.
- Many employers will offer some sort of matching contribution on money going into your 401(k) retirement plan.
- Once you are in a workplace retirement plan, typically providers include brokerages such as Fidelity. These brokerages can help you with customizations to your 401(k) investments to make the most of your growth potential.
There are some negatives to a traditional 401(k) to consider. They include:
- With a 401(k), you may have limits to what you can invest in. There will be no exotic investment options, as many will allow for stable long-term growth.
- When you participate in an employer 401(k), you have no control over any account fees you pay. To participate, you may just have to pay the fees no matter their cost.
- If you need access to the money before retirement, you will likely pay an early withdrawal penalty. The penalty is typically 10%, on top of the standard tax rate. Only a qualifying hardship allows you to avoid the penalty tax.
Other Options in the Market
There are other options in the market when it comes to retirement accounts. The most common alternative to a 401(k) is a Roth retirement account. The big difference with a Roth retirement account is you are paying taxes upfront on your contributions. When you withdraw your funds later, all of your contributions and the earnings on those contributions are tax-free.
You have options when it comes to the Roth in a Roth 401(k), Roth 403(b) as well as a Roth IRA. A Roth IRA has an income limit to qualify, but this limit is not in place for the other Roth options. Roth is an alternative to the traditional 401(k) your employer offers, which may be worth exploring.
Many options exist when it comes to preparing for and planning retirement. You want to be sure you have good financial backing before you begin the leisure stage of your life. Understanding your 401(k) retirement plan options is critical, as well as alternatives, so you can make the best decision possible.