Years ago, it was common for employers to offer a pension plan to support workers after they retired. Over the past few decades, however, most employers have stopped offering pensions, and many offer a 401(k) retirement plan instead.
With a 401(k) plan, you are in charge of your retirement account. That means you are in charge of how much money you will have in retirement. While that may seem intimidating, the biggest step is simply to start contributing to your plan.
And remember, you don’t have to go it alone. A financial planner can help you make decisions that reflect your goals and risk tolerance.
How a 401(k) plan works
In general, a 401(k) is a retirement account that your employer sets up for you. When you enroll, you decide to put a percentage of each paycheck into the account. These contributions are placed into investments that you’ve selected based on your retirement goals and risk tolerance. When you retire, the money you have in the account is available to support your living expenses.
Your contributions are tax-deferred
Your 401(k) contributions are deducted right from your paycheck and go directly into your account before taxes are withheld. So if your salary is $50,000 a year and you contribute $3,000 to your 401(k), you will pay income tax on $47,000 next April instead of the entire $50,000 that you earned.
When you withdraw money from your account in retirement, it will be subjected to taxes. But since you’ll be retired, you’ll possibly be in a lower tax bracket.
Take full advantage of the tax-deferral by contributing the maximum amount allowed by your company. Check with your human resources department for limits and details. Please keep in mind that all investing involves market risk, including the possible loss of principal.
You may get free money from your employer
Your company may match a certain percentage of your 401(k) contributions – most do. For example, if your company matches 0.5% for every 1% you contribute up to 6%, that translates into an extra 3% in your account if you take advantage of the entire match.
With the example above, your $3,000 contribution plus your employer’s match would add $4,500 to your 401(k). That’s like receiving free money just for participating in your retirement plan. (Your company will have rules about when the entire match is yours. Get the details from your employer.)
You can avoid penalties by leaving your money in your 401(k)
Since 401(k)s are designed to help you save for retirement, there are stiff penalties for taking your money out early. You’ll owe income taxes on the total amount and, if you're younger than 59½, also may owe a 10% early-withdrawal penalty. Plus, the IRS requires your employer to withhold 20% of your account value to pre-pay at least part of the taxes you’ll owe.