You’d be hard-pressed to find an article giving basic financial advice that doesn’t mention the importance of 401(k)s — and especially an employer match on a 401(k). But rarely does such advice take the time to talk in detail about why.
Here’s your answer — once and for all, and with all the details — to the question: “What is a 401(k)?”
What is a 401(k)?
Simply put, a 401(k) is a retirement plan sponsored by your employer. Although you can start your retirement plan with a traditional or Roth IRA, you can only get a 401(k) through your work.
Here’s how a 401(k) works. When you get a new job, you’ll find out if your employer offers a 401(k) plan as part of your benefits package. Some have plans that auto-enroll you if you do nothing, although you’re not required to join or stay in the plan, nor are you required to contribute the amount the auto-enrollment sets up.
There are also employers that only offer this benefit after you’ve been at the company for a set amount of time. This is similar to health insurance benefits, which could be offered the day you’re hired, or might instead come after a probationary period of employment.
If you opt into a 401(k), you get to choose your contribution amount. In other words, you’ll decide on a certain percentage of your paycheck to have withdrawn (pre-tax) and put into your 401(k). That account is then invested, and you can change your contributions or investment portfolio anytime.
The best benefit of the 401(k): The employer match
In short, a 401(k) is a way your employer can help you save for retirement, using investment accounts that help your money grow so you don’t lose out to inflation by the time you’re ready to stop working.
And many employers sweeten the deal by matching whatever you pay into the 401(k) with a contribution of their own, up to a certain limit (usually a percentage of your salary). It’s often recommended to contribute at least the same percentage of your own money that your employer will match so that you don’t lose out on free money. But you’ll want to read the fine print on your match to see exactly how it works.
For example, your employer might say they offer a 6 percent match, but the details could indicate that they’re paying just 50 percent of whatever you contribute, which means they really offer a 3 percent match. Or they might offer the match at a 100 percent rate, but only if you pay in a certain percentage of your own money.
The list of variants can go on and on. According to Forbes, investment company Vanguard has 225 formulas for administering these matches. The easiest way to handle those variants is to read carefully, and ask your HR department for help if you don’t understand how your company’s program works.
How you can use a 401(k) to save for retirement
Now that you know what a 401(k) is, the next question is how to utilize one to save for retirement. The answer is fairly simple.
If you decide to enroll in a 401(k), deduct at least as much as your employer matches (if you can afford to do so). Then read this article to see how much you’ll need to save for retirement and use this calculator to get an idea of how your investments might perform as your 401(k) grows. That way you’ll know how much you can expect to retire with at your current rate of savings.
And if your 401(k) fees are high, or if you’ve hit your contribution limits, look into other retirement savings vehicles, such as IRAs, if you have the extra money to put away.
Finally, remember that some employer matches vest, which means you don’t get the full amount of the match until you’re at the company for a specific amount of time. If you leave before that, you’ll only get a percentage of the match you might have been planning on.
Either way, any time you leave your company prior to retirement, you can roll over your 401(k) to an IRA or your new employer’s 401(k). (You can also cash out, but that would mean liquidating your retirement savings early and possibly paying a hefty tax penalty.)
What financial experts have to say about the 401(k)
Just because a 401(k) is offered doesn’t mean you have to take it. So, should you? Here are some tips from the financial professionals.
Try to make the deductions work
If you’re living paycheck to paycheck, you might find it difficult to justify removing funds from your pay for savings you’ll use later.
That said, the pre-tax deduction that a 401(k) uses means the reduction to your take-home pay won’t be so bad. As financial planner and blogger at Mom and Dad Money, Matt Becker, explains:
“Your 401(k) is a great place to start investing, no matter how much you’re able to save. You can automate contributions, big or small, which allows you to make consistent progress month after month. And because your contributions are tax-deductible, the hit to your paycheck is often less than you think.”
Utilize that company match, and don’t be afraid to get started
Becker goes on to say that it’s a good idea to “take full advantage of your 401(k) employer match before even considering investing elsewhere,” since it can be a huge boost to your retirement savings. And, he explains, you don’t have to be an investing expert to get started:
“It’s much better to contribute money, make mistakes, and learn as you go, than to delay participating at all. Your contributions will far outweigh any returns you earn at the start anyway, so there’s really not much risk.”
The 401(k) is a good way to automate savings — but watch out for fees
Financial coach Dylan Ross echoes Becker’s sentiments about using a 401(k) to kickstart your savings, calling these plans “one of the best savings tools,” since they come out of your paycheck before your bills do.
What’s more, he says, “maintaining good savings habits is not easy, but a 401(k) makes it simple to pay yourself first.”
So what’s the downside? The fees, says Becker:
“Beyond taking advantage of your employer match, the big thing to watch out for is fees. Some 401(k)s only offer high-cost investments, and in that case, you may be better off maxing out an IRA before making additional 401(k) contributions.”
There’s no time like the present to start saving for retirement
Knowing what is a 401(k) is great, but don’t downplay the importance of retirement savings tools like this just because you’re young or in debt. Thanks to compound interest, starting early can make a huge difference. For example, a person who saves for 40 years with a six percent annual return will end up with almost double what they’d have if they had only saved for 30 years.
And with a 401(k), the savings is so easy to do that it’s hard to find a reason not to (especially if your company offers a match). No matter how early you are in your career, there’s simply no better time than now to turn on your retirement savings engines.
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