Retirement may seem light-years away or it can feel like its right around the corner. Regardless of the time horizon, any financial planner worth their salt will tell you that planning for your "golden years" should start as early as possible. While it can be hard to think so far ahead, most companies today offer a 401(k) plan.
A 401(k) is an employer sponsored retirement savings plan that is oftentimes part the company’s benefits package. A 401(k) plan enables you to defer money from your paycheck to be put into your 401(k) investment account. Not only can you fund your own personal account, your company can contribute on your behalf as well. Many companies will "match" a portion of your contribution. This is free money they are offering you.
Usually, the plan will have a pre-determined percentage of pay that is deferred from your paycheck, but we highly suggest you alter the dollar amount contributed due to the fact that everyone has different needs financially and the amount should be specific to you. You may choose to increase or decrease your contributions depending on your financial situation and your company’s offerings. For example, if your employer matches 100% of what you put in and you are financially stable, you may want to contribute as much as you can to your 401(k). Naturally, this is not the best idea for everyone.
Understanding your company’s 401(k) plan is the first step to making the most of it.
“The secret of getting ahead is getting started.” – Mark Twain
Discover What Plan(s) Your Company Offers
Traditional Pre-Tax 401(k)
With a traditional 401(k), you will save realize a tax savings immediately. First, your reported income will be reduced by every dollar contributed to the 401(k) potentially lower your tax bracket. Second, once the money is inside the account, all trades and profits will grows tax-deferred. You will not have to pay taxes on any gains in a given year. However, you will have to pay tax on the amount you withdraw during retirement.
With a Roth 401(k), all contributions are made with after-tax dollars, meaning you will definitely pay more taxes in the year contributed and potentially remain in a higher tax bracket. Along with the Traditional 401(k) no gains are taxed inside a Roth. The major benefit of a Roth is not paying taxes in retirement on the amount withdrawn from a Roth. However, your account will grow tax-free, and you’ll withdraw money tax-free during retirement.
Unlike the traditional 401(k), you’ll save on taxes in the future rather than in real-time.
For the tax year 2020, the contribution limit will be $19,500 per individual. If you have multiple plans, the combined contributions are capped at $19,500.1
Choosing the Right 401(k) Plan for Your Situation
If your employer offers both a pre-tax 401(k) and a Roth 401(k), you’ll have to decide which plan is right for you and sometimes it's a combination of both. You’ll pay taxes on a pre-tax 401(k) when withdrawing, but you’ll pay taxes on Roth 401(k) contributions now, and this difference will play a role in choosing the best plan for your needs.
A general rule of thumb is to make contributions to a Roth account while in the earlier stages of your career. This is because people typically have a lower salary while starting out and your tax rate will not be as high. In this way, the impact on your dollars will not be as severe as it would be with a higher tax rate due to a higher salary. On the other hand, you may prefer to make pre-tax contributions during the later stages of your career when your salary is higher because your tax rate will also be greater.
The key is to understand how these decisions will affect you down the road.
Should You Also Open an IRA?
Aside from your employer sponsored 401(k) plan, you could open an Individual Retirement Account (IRA). This could potentially be a better option for those who want professional guidance or are they are only offered a traditional 401(k) plan. In this scenario, opening a Roth IRA enables you to make after-tax contributions where as you would not be able to otherwise.
Understand Your Investment Options
Many plans will allow you to choose between multiple types of investments, like different mutual funds. You’ll want to thoroughly explore these options and consider which one is right for your circumstances.
Is Your Employer Contributing to Your 401(k)?
As mentioned above, your employer may also contribute to your 401(k). These contributions are pre-tax, so you’ll only pay taxes on the money when it’s withdrawn in retirement. There are several types of employer contributions:
|With a matching employer contribution, your employer contributes the same amount as you. In some circumstances, there is a minimum amount at which your employer will contribute. If this is the case, some may decide to contribute at least the minimum.|
|A non-elective employer contribution means that your employer will put in the same percentage for every employee, even if the employee is not contributing.|
|In a profit-sharing 401(k), employers will delegate a percentage or dollar amount of the company’s profit to employees’ 401(k) accounts.|
Find Out When Your Employer Contribution Dollars Are Yours
Frequently, as an incentive for employee's to stay at a current job, an employee can only keep its employer’s contributions after a pre-determined number of years in the company, otherwise known as “vesting.” When you’re fully vested you own 100% of the contributions made by your employer. If not, they will be able to take back a portion of the funds contributed by the company.
If you want to make the most of your employer’s plan, you’ll want to find out when you are vested. You may decide to part ways with your job only after you are vested, allowing you to take full advantage of your company’s 401(k) plan.
Once you understand the specifics of your company’s 401(k) offerings, you’ll be able to decide how to make the best of the plan for your needs and goals. Sometimes getting started is the hardest part and you may find yourself frozen and unable to make a decision about which direct is best for you. If this is the case, please use the button below to schedule a free consultation with one of our financial professionals. We would love to help make the right choice for you!
|About the Author|
James M. Comblo , CFF
is a Partner and the Chief Compliance Officer at FSC Wealth Advisors. His greatest passion in the financial services industry is helping clients accomplish their dreams both with investments and their personal lives. To learn more about him click here.
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