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One of the smartest money moves you can make is saving for retirement. Here is a rundown of all the basic information you need to know about the 401(k) retirement savings plan.
What is a 401(k)?
A 401(k) is a retirement savings plan offered by an employer. A Traditional 401(k) allows you to contribute and invest some of your paycheck before taxes are taken out. Taxes are not paid until the money is withdrawn from the account. A Roth 401(k) allows you to contribute and invest some of your paycheck after taxes are taken out. No taxes paid upon withdrawal.
401(k) plans, named for the section of the tax code that governs them, arose during the 1980s as a supplement to pensions. Most employers used to offer pension funds. Pension funds were managed by the employer and they paid out a steady income over the course of the retirement. Some jobs still offer a pension. As the cost of running pensions escalated, employers started replacing them with 401(k)s. With a 401(k), you control how your money is invested unlike most pensions. Most plans offer a spread of mutual funds composed of stocks, bonds, and money market investments.
Many employers offer to match a portion of what you contribute. The rules for matching funds vary, so be sure to check with your employer about qualifying for its contributions. For example, let’s say your employer offers a 5% match. If you contribute 5% of your $50,000 salary, or $2,500, your employer puts another $2,500 in your account annually. You can contribute more than the $2,500 yourself, but your employer will not match beyond 5%.
While a 401(k)can help you save, it has some rules. In most cases, you cannot tap into your employer’s contributions immediately. Vesting is the amount of time you must work for your company before gaining access to its payments to your 401(k). Your payments, on the other hand, vest immediately. On top of that, there are complex rules about when you can withdraw your money and costly penalties for pulling funds out before retirement age.
The IRS mandates contribution limits for 401(k) accounts. For 2018, the most you can put into your fund is $18,500 in any combination of pre- and after-tax dollars. For example, you could contribute up to 37% of your $50,000 salary in 2018. Those age 50 and older can save even more by making what is called a “catch-up” contribution. That is limited to $6,000 a year.
When to Start Contributing?
With all that settled, when should you start contributing? In most cases, you should only contribute to your 401(k) plan if you have a savings account that serves as an emergency fund, when you have adequate insurance coverage in place, and once you are debt free (except for your home). Your 401(k) contributions are for retirement, not for emergencies or personal expenses.
Some financial advisers do not believe in delaying 401k contributions. They will advise you to get your financial act together fast and just contribute enough to get the employer match until then.
It is ultimately a personal decision. You should do a risk assessment to determine how much financial security you need to acquire before you start investing. Do you need to make sure you have insurance, emergency fund, and are debt free before you start investing? You should really look at your situation and determine if that is the case. For example, someone who is living at home working their first job after college does not have the same risk as someone who is married with family members depending on their income.
I will dive further into this topic in another blog post. Once you start contributing, be mindful that you will need to have enough money to live and maintain your four walls. You can increase or decrease your contributions at any time depending on your personal situation.
Comment below and let me know where you are on your journey to financial freedom. That is, are you paying off debt, saving for emergencies, or contributing to your 401k?
- Wall Street Journal: http://guides.wsj.com/personal-finance/retirement/what-is-a-401k/
By Simone, creator of @SlimFitWallet