Know Your 401(k) Basics

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You’ll Thank Yourself Later

Back in our parents’ and grandparents’ day, most companies gave employees pension plans, which guaranteed a decent living standard for workers after retirement.

In the 1980s many companies replaced pension plans with 401(k) plans, which made workers manage their own retirement savings. But 401(k) plans were not created with low- and middle-income workers in mind.

The name 401(k) comes from the Internal Revenue Service tax code. It was created in the 1970s as a way for higher-paid executives to shield some of their money from taxes. While our grandparents’ pension plans were guaranteed by the employer, today’s 401(k) plans typically are not guaranteed and are managed by private investment firms who make a profit off the funds through management fees.

All this to say, 401(k) plans are complicated. They have highly complex rules and often carry hefty fees and penalties for early withdrawals or lump-sum payouts. If your employer offers a 401(k) or similar retirement savings plan, you are wise to take advantage of it.

You will get the most benefit if you take the time to learn about your company’s 401(k). Don’t be afraid to ask your human resources department or brokerage firm to explain your options to you. You might not be a high-paid executive, but with the right information, you can turn your 401(k) into a powerful source of future income with very little effort on your part.

What it is: Typically 401(k) plans invest in a portfolio of mutual funds, but can include stocks and bonds. Target-date funds are a common option because you don’t have to choose what to invest in. The fund manager automatically adjusts investments for higher and lower risk depending on when you plan to retire (the investments are riskier when you’re younger, and less risky as you get closer to retirement).

How it works: You fill out a Salary Reduction Agreement that tells your employer how much to take out of your paycheck to put into your 401(k) fund. Usually this is a percentage (like 6 percent). You can contribute up to the yearly limit ($18,000 for 2017). Many employers offer matching contributions, so if you put in 3 percent, your employer will “match” you by adding another 3 percent.

Taxes: Your contributions are directly deposited into your 401(k) by your employer before taxes are taken out. You pay taxes when you withdraw the funds. You can start withdrawing from your 401(k) without penalty at age 59 1/2, and you are required to start withdrawals at age 70 1/2.

Hardship withdrawals and loans: If you choose to take this money out early for any reason, you often must pay large penalties and taxes.

Watch out for: High management fees. Make your HR representative or broker explain the fund fees to you and do your own research into average brokerage fees, especially if you get to choose among several brokerage firms.

Dig deeper: Visit IRS.gov for detailed information on contribution limits, penalties and withdrawals.

Invest in Your 401(k) Now and Get the (BIG) Payoff Later

But, the tough question is, how much should you contribute? The answer is – as much as you can, and as early as you can.

If you started investing at age 18 and only contributed to your savings for 10 years, you could have more money at age 65 than someone who started at age 31 and invested for 35 years. You could put in $20,000 over a 10-year span, and the other person could put in $70,000 over a 35-year span. Yet, thanks to compound interest, you would have significantly more money.

How is that possible? The answer is that your early investments grew fast and quick in the beginning, and then had a long time to mature and build.

Even though the other person paid $50,000 more than you did into their retirement fund, their investment couldn’t catch up because they simply didn’t have enough time for interest to grow.

Time is your greatest ally when it comes to investing. If you are waiting to start investing until you are making big bucks later on in your career, you are throwing away the most powerful asset you have. Start young, and you won’t have to work as hard later to catch up. (And, also, it’s never too late to start.)

As usual, we’ve got your back. — The OYO Team

[Any reference to a specific company, commercial product, process or service does not constitute or imply an endorsement or recommendation by On Your Own, the National Endowment for Financial Education or any of its affiliate programs.]