August 30, 2021Understanding 401(k) Plans
While retirement may seem like a lifetime away for many, making smart investing decisions early is the best move to ensure you can retire comfortably down the road. There are several retirement accounts to consider, such as Roth IRAs and 403(b) accounts, but one of the most popular options for many is a 401(k) plan. Since most employers offer an easy-to-set-up, low-risk employee 401(k) plan with matching contributions, taking advantage of this option is a no-brainer.
Your company’s HR specialist can help you understand the specifics of your company’s 401(k) offerings, but it’s a good idea to have a basic understanding of how 401(k) plans work and how they can benefit you. After you learn the basics, it will be easier to figure out what questions to ask to make the best investment decisions regarding your 401(k).
What is a 401(k)?
A 401(k) is tax-advantaged savings account for retirement. Eligible employees can contribute a portion of their regular paycheck to the account as part of a long-term savings plan. Unlike a traditional savings account, you have greater flexibility in choosing where to invest your money in order to earn higher returns.
It’s important to remember that a 401(k) is a retirement account, and the funds you invest are meant to remain untouched until you reach your golden years. You want to make sure you only invest what you can afford initially. Once you’re more comfortable, you can begin increasing your contributions.
Many companies offer 401(k) plans as a part of their employee benefits package. These plans are provided as an opportunity to prepare for the future. Some of these companies will even match up to a certain percentage of what the employee is contributing. For example, an employer may contribute 100% of the first 4-5% that the employee contributes.
To illustrate, review the following scenario:
Let’s say your employer matches 100% of the first 5% you contribute. If you contribute 5% of your $2,000 paycheck, or $100, your company will also put $100 into your 401(k). If you contribute 3% or $60, then your company will contribute $60. However, if you decide to contribute 6% or $120, your employer will only contribute up to the 5% limit, or $100.
Benefits of a 401(k) Savings Plan
There are many benefits of a 401(k) Savings Plan, including:
- It’s free money. With most employer-based 401(k) plans offering to match up to a certain amount, it’s like you’re getting free money. And, if you’re not taking advantage of this benefit, you’re losing out on a significant amount of retirement income.
- It offers tax breaks. All funds deposited into your 401(k) plan are tax-deductible. What this means is that all annual contributions are not figured into your gross income. This lowers your taxable income. Plus, the money you invest grows tax-deferred in a 401(k) plan, compared to it being taxed on dividends or interest in a savings or brokerage account at the end of each year.
- It’s practically effortless. You simply sign up, choose your options, and finalize the paperwork. Then, your employer automatically deducts your contributions from your paychecks.
- It bypasses large minimum investment requirements. Many mutual funds have minimum investment limits that can be quite substantial for a young professional. If you want to save for your retirement but don’t have enough funds for the minimum investment these mutual funds require, a 401(k) plan lets you invest in similar types of funds with no minimum investment requirement.
Variations of 401(k) Plans
There are variations of 401(k) plans that are taxed in different ways. For instance, you can be taxed on the money you earn or later on when you withdraw the funds. A Roth 401(k) is when you pay the taxes upfront rather than when you withdraw it, as you would with a traditional 401(k).
They both have their own benefits and can be utilized to match your needs. There are employer restrictions on Roth 401(k) plans, so it’s essential to speak with your company HR administrator or financial advisor before deciding which option is best for you.
Penalties for Withdrawing Money
While you are able to withdraw funds from your 401(k) before your retirement, this will trigger penalties and may not be worth the loss of funds. For instance, if you withdraw your money before you are 59 ½ years old, you could face a 10% tax penalty. In addition, the money you withdraw will be treated as income and taxed at your current rate.
However, there are instances when tapping into your 401(k) may be worth it despite the penalties. For example, during the pandemic, many people lost jobs and had no income for extended periods of time. If you face such a predicament, your financial advisor can help you calculate precisely how much the withdrawal will cost.
We’re Here to Help!
Retirement planning is a long-term game that requires patience and consistent work. 401(k) plans are one of the many options available to help you build a nest egg for your golden years. Because many employers match contributions, it’s a great way to save and essentially earn free money.
As your credit union, we’re here to help you navigate the retirement planning process. With various savings and retirement accounts, our team will work with you one-on-one to find the best options for you.
Please stop by any of our convenient branch locations or call (863) 226-6673 to learn how we can work together to secure your financial future.
Each individual’s financial situation is unique, and readers are encouraged to contact PEFCU when seeking financial advice on the products and services discussed. This article is for educational purposes only; it does not constitute legal advice. If such advice or a legal opinion is required, please consult with competent local counsel.