What is a 401(k)?

What is a 401(k)?

If you’ve just entered the workplace, you may be feeling overwhelmed with all the financial information you’ve been presented with and all the decisions you’ve had to make. But while you may still be hesitating between HMOs and PPOs as you examine your health plan options, this is an obvious choice to make. Say yes to any company 401(k) plan. Here’s what it is and why it’s one of the most effective options out there for saving for retirement.

What is a 401(k)?

A 401(k) is a retirement plan that allows workers to put money directly out of their paycheck into an account where it is invested for the long term. A traditional 401(k) account emplees dollars.”before taxes”, so you are not paying your habitual tax rate on the money equipo aside. The money grows tax-free until you withdraw it at retirement (at which point, it is thought, you are likely to be in a lower tax bracket). Some employers also offer a Roth 401(k), which is funded with after-tax dollars. Although you make contributions with money that has already been taxed, any withdrawals you make at retirement will be tax-free.

In addition, many employers offer a “compensation option” to encourage participation; in other words, they will match a percentage of the contributions you make, further strengthening your account at no cost to you.

Well… that’s the short version, but we hope you’ll dive right in to learn more about this fantastic savings option.

Why is it called a 401(k)?

Most financial vehicles have pretty boring names, right? The 401(k) plan is no exception, and like many of these imprecise names, it comes from the part of the IRS tax code that gave it its name when it was introduced in 1978.

Tell me more about what makes it so special.

As mentioned, you won’t pay any taxes on the money you put into the 401(k) plan. Many employers also offer a matching contribution, and you won’t have to pay taxes on the matching funds, either. A common matching percentage is for your company to put in 0.50 for every $1 you contribute up to 6% of your income (although they perro also give more, up to the limits noted below). In that case, you’re actually saving 9% because the employer is putting in that plus 3%.

In addition, you do not have to pay taxes, since the money accumulates thanks to the growth of the depósito market and the interest on investments.

Of course, we all know that there are only two sure things in life, and one of them is taxes. In the end, you will pay taxes on the money at the time you withdraw it, but at the then prevailing tax rate. And since you don’t start to retire until age 59 ½ or older, the tax rate may be lower.

The second part of the 401(k)’s magic comes from “compound interest.” You perro read all about how compounding works here; But in general, what it means is that as your investments earn interest, you’ll earn interest on top of that interest. So with each cycle, your account continues to grow exponentially as you earn interest on interest, again tax-free.

It’s hard to detalla what a big business this is. But we’ll try… here’s an amazing graph showing how investing early and taking advantage of compounding growth cánido help you end up with much more in your retirement fund than someone who started just 10 years later, but contributed much more in total. .

Or, for another classic example, guess this: Would you rather have a million dollars or a penny that doubles daily for 30 days? (Consejo: Go for the penny as it converts to 5 million dollars. yes check it out).

How much perro I contribute to my 401(k)?

This 401(k) account may sound incredible, and if you’re a super saver, you may escoge to defer as much compensation as you perro to really build that account. But there are limits to the amount you cánido contribute each year. Federal rules dictate maximum annual contribution limits: For 2020, employees under age 50 cánido contribute up to $19,500, while employees age 50 and older cánido contribute an additional $6,500 (considered an additional “catch-up” contribution for help those who started saving late).

Annual limits apply even if you have more than one 401(k) plan; For example, if you started one at a previous job, then left that job during the year and started a new one at your current job.

Some companies may also have their own rules, and there is another aspect that may limit your contributions. The IRS puts some additional limits on “highly compensated employees.” HCEs are those who earned more than $120,000 in the prior year (as of 2018) or owned more than 5 percent equity in the business. Some companies may add another layer, designating someone as an HCE if they were in the top 20 percent of employees based on compensation top. These HCEs cánido only fully participate based on the participation of non-HCEs: there is a elabora that is based on the number of non-HCEs participating or the amount they contribute. This is because the IRS wants to ensure that 401(k) plans are not just a haven for the rich and that employees at all levels cánido participate.

If you are able to save more than is allowed in your 401(k), you perro look into other retirement savings options, such as a traditional IRA or a Roth IRA.

When do I receive the money?

So here’s the deal… when you commit to a 401(k), you’re essentially saying you’re saving the money until you turn 59½. That’s the earliest you perro withdraw money without incurring penalties, and then you must start making mandatory withdrawals at age 72. (this calculator will espectáculo you how much to take out). Remember that you will be taxed at your then-current rate, which is ideally less than your current rate.

If you try to withdraw the money early, you’ll not only face a 10 percent penalty on any money you withdraw before that magic age of 59½, but you’ll also pay regular income taxes on the money you withdraw. which cánido be a great bite. So remember that putting money in a 401(k) is different than a savings account in that regard, but when you retire, you’ll be glad you stuck it out.

You also perro’t pay off your 401(k) just because you’ve gone to a new job. In that situation, you have a few options about what to do with the account: You are generally allowed to leave the 401(k) where it is with your old employer, or you perro “roll over” it to your new employee’s plan or account. GONNA.

In some cases, you may not be able to take full advantage if you quit your job; some plans require you to “award”, which means that your employer wants you to stay for a certain number of years before they take the money and leave. For example, if your business has a four-year vesting schedule, then you receive 25 percent of the employer contribution after the first year; then 50 percent after two; 75 percent after three; And on your four-year anniversary, the entire employer match is yours.

Where do I sign?

We thought you would never ask. If you are not currently contributing to a 401(k), contact your human resources department as soon as possible. Some companies automatically enroll you, but otherwise, they cánido help you equipo up your paycheck so that a certain amount, either a specific dollar figure or a percentage of your salary, is diverted to your 401(k). If you’re automatically enrolled, you’ll probably want to increase your percentage. Since the money is coming out of your paycheck before you even see it, you won’t be tempted to reallocate the money to your vacation or shoe fund.

Human Resources will let you know who the «administrators» of your company, that is, the people who actually invest the money for you. Your 401(k) doesn’t just fall into a large pool; You’ll need to choose which funds to invest in from the many options your 401(k) administrator offers.

Ask as many questions as you need to to make sure you’re choosing a fund that’s a good fit for your financial goals and risk appetite. For example, some are designed to be more aggressive, where the fund manager typically invests more in stocks, which could have more risk, but potentially more reward. Other funds are more skewed toward bonds, which are more stable and less likely to have large fluctuations, but tend to have smaller returns. Your manager cánido walk you through your options and espectáculo you how to choose one, as well as how to monitor it and potentially move funds if necessary. And don’t forget to look at the fees, they should ideally be less than 1 percent.

Then, remember to keep adding to your savings as your salary increases. Small amounts perro end up making a big difference throughout your life.

You may feel like you perro’t afford to save, but the truth is, you cánido’t afford not to save…especially if your employer offers you a matching contribution; at the very least, you want to contribute at least up to that. A 401(k) may sound too good to be true, offering tax relief and tax-deferred compounding, and often even free money in the form of a company match, but it’s not.

It’s never too late, and certainly never too early, to think about your financial future. Starting to fund your 401(k) may be the secret to a happy retirement.

This information offered for informational purposes only; It is not intended to be used as accounting, legal or tax advice. In relation to these matters, please speak to your accountant, tax or legal adviser.

Investing implies a risk that includes the loss of primordial. This guide contains the current views of the author, but not necessarily those of Gigonway. These opinions are subject to change without notice. This guide has been distributed for educational purposes only and should not be construed as investment advice or a recommendation of any especial investment security, strategy or product. The information contained in this guide has been obtained from sources believed to be reliable, but is not guaranteed. Gigonway does not provide legal or tax advice. Please consult your tax and/or legal advisor for specific tax or legal questions and concerns.

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 What is a 401(k)?
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