It’s wise to take full advantage of your employer’s retirement savings plan. The best reason for participating in a 401(k) plan is that it can help put you on the road to long-term financial security. However, reaching that goal is increasingly your responsibility – through your employer and the federal government help by making a tax-advantaged savings plan available through your job.
What is a 401 (k)?
A 401(k) is an employer-sponsored retirement account. It allows employees to dedicate a percentage of their pre-tax salary to a retirement account. The name 401k comes directly from the Tax Code section that established this type of plan.
The money will be invested for your retirement, usually choosing various mutual funds.
The government sets an annual dollar limit on the amount you can contribute, and there’s a catch-up contribution for anyone 50 or older. Your employer may also cap your contribution at a percentage of pay.
With automatic enrollment, your employer chooses the rate at which you contribute and the investment into which your contributions go. You have the right to withdraw from the plan if you wish and to change the rate at which you contribute or how your money is invested.
What are the benefits of a 401(k)?
The realization of your retirement dreams will not happen by accident. To live the retirement lifestyle you dream of, you need to start saving. Your retirement plan can be one of the best tools available to help you build your financial future.
Here are the benefits of most traditional 401(k) plans:
- Tax advantages
You immediately start paying less when you contribute a percentage of your pay to a 401(k) plan. That means you can deduct your contributions in the year you make them, which lowers your taxable income for the year.
If you retire to a state with no or very low state income tax, you’ll be that much further ahead.
- Employer match
Many employers will match a portion of your savings. Here’s how those employer benefits can work. Many companies offer to match 50% of up to the first 6% you contribute to a 401(k). For example, if you receive a salary of $46,000 and contribute 6% of your annual earnings ($2,760) to your 401(k), your employer would contribute an additional 50% of that amount. That’s $1,380 of easy money.
- Retirement Plan Loans
You might be able to take out a loan from your 401(k) plan for specific reasons, such as buying a primary residence, paying for education or medical expenses, or in case of severe economic hardship. Generally, your retirement plan loan must be paid back within five years, so it’s a short-term loan.
Getting Started with your 401(k)
Building a strong 401(k) portfolio doesn’t just happen. But it’s worth the time and effort it takes. So whether you’re making investment decisions for the first time, or you’re putting your retirement savings portfolio in shape, you’ll want to consider four key factors:
Other retirement assets
Knowing what portion of your long-term retirement planning your 401(k) account represents is essential. For example, suppose it’s just one part of a total portfolio that includes an individual retirement account (IRA), taxable investments, and perhaps a pension or deferred annuity. In that case, you may be comfortable concentrating your 401(k) contributions in just a few of the best-performing alternatives your plan offers. But if your 401(k) is the only money you’re putting away for retirement, you may want to balance your portfolio, allocating your account value across the asset classes that are available in the plan.
If you have many years of work ahead of you, you can afford to take greater risks with your 401(k) account. You may want to invest the bulk of your money in stock funds and perhaps a small percentage in company stock if it’s available. Then, if an investment doesn’t perform as well as you expect – because the manager’s investment style is out of favor or the stock market is in a slump – you’ll have time to recoup the loss.
On the other hand, if you’re planning to retire pretty soon, you may want to gradually shift some of your assets into less volatile investments to generate income and preserve what you’ve accumulated. Remember that it’s important to keep at least a portion of your assets focused on growth even after you retire.
Your future income needs
Projecting your future income needs can determine how aggressively or conservatively you should invest. For example, you can assume that you’ll need at least 75% to 90% of your final preretirement income to live comfortably after you stop working. Next, you’ll want to figure out how much of that amount will come from other sources, including any pension, individual retirement plan, or annuity payments you may be eligible for, plus what Social Security will provide. Everyone over 25 who is part of the Social Security system gets an annual statement with an estimate of future benefits. If you’re younger than 25, you can request a copy.
Your tolerance for risk
The risk-return tradeoff you’re willing to make is a key element in your investment decisions, both inside and outside your 401(k). It’s a well-known fact that investments posing a greater risk to your principal offer potentially greater returns and a greater probability of losses, at least in the short term.
If you’re not comfortable assuming any risk, it’s best to recognize that fact – and its consequences – early on. For example, suppose you put most of your contributions in insured liquid investments. In that case, you run up against inflation risk and the very real possibility that your buying power won’t keep up with your spending needs.
Basic 401(k) strategies
Look at these three hypothetical combinations to get a feel for putting a 401(k) portfolio together. Each is designed to show a level of risk-taking that might be appropriate at a particular stage in your career. Unless you invest your 401(k) using a brokerage account and purchase individual securities, these allocations apply to various funds available through your plan.
Tax-deferred and Roth IRA
Tax-deferred 401(k) plans let you defer pre-tax salary to your account and accumulate tax-deferred earnings. The amount you defer reduces your current taxable income. Then, after you retire, you pay income tax on the amounts you withdraw from the plan at the same rate as you pay on your other taxable income.
In the last few years, a growing number of employers with tax-deferred 401(k)s have begun to offer the option of contributing to a Roth 401(k) instead. If you choose this alternative, you defer after-tax rather than pre-tax income and pay no tax on earnings as they accumulate. When you retire, if you’re at least 59½ and your account has been open for five years. Moreover, any withdrawals are free of federal income tax and often state income tax.
Any employee eligible to participate in an employer’s 401(k) can choose to contribute to the Roth option if it’s available. There are no income restrictions as there are with a Roth IRA.
Both tax-deferred and Roth 401(k)s require minimum withdrawals after you turn 70½. But, if you roll over your Roth 401(k) or convert your tax-deferred 401(k) to a Roth IRA, you can eliminate the required distributions. Withdrawals from the Roth IRA are tax-free under the same conditions that apply to a Roth 401(k).
Asset allocation for your 401k
Asset allocation is a strategy for increasing investment return while helping to manage investment risk. Divide and conquer is often the best way to win your investment battle.
You allocate by assigning percentages of your overall portfolio to different categories of investments known as asset classes.
When you’re putting money into a 401(k), you’re essentially concerned with three primary asset classes:
- Equity investments, including stocks and stock mutual funds.
- Fixed-income investments, including bonds and bond mutual funds.
- Capital preservation investments, including money market funds and stable value funds.
Since you want to choose the asset allocation that suits you perfectly, you need to consider your investment goal. For example, if your target is maximum long-term growth, you may want to emphasize stock and stock funds. On the other hand, if you’re getting closer to retirement, you may want to gradually shift the proportion of stock and bonds or other fixed-income securities.
Investing In A 401(k) For Beginners. Complete Guide by Inna Rosputnia
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