You may have heard of the term 401(k) from your employer, coworkers, or parents.
Today we are breaking down what a 401(k) is and the things you should consider before you enroll.
How does it work?
A 401(k) helps working Americans save for retirement. When participating in a 401(k) you elect to put a percentage (or fixed amount) of your wages into a separate account, your 401(k) plan. An outside company then invests that money on your behalf. In order to incentivize people to participate in the plans, the government offers present or future tax breaks on the money you contribute to your 401(k).
Many employers provide an additional incentive to employees by matching their contributions. For example, if you are making $50,000 per year and you elect to contribute 3% of your income to your 401(k), you will be contributing $1,500 per year. If your employer matches, your company will also contribute $1,500, giving you a balance of $3,000 for the year. The employer match helps your 401(k) account grow quickly but keep in mind there is usually a limit to how much they will match.
Ask an HR or payroll representative to find out what the employer match limit is at your company.
Traditional vs. Roth
A traditional 401(k) gives you a tax-deferred incentive. For example, if you contribute $1,500 to your 401(k) this year, when you file your tax return for the year, the $1,500 will not be included as income. However, when you retire and you start taking distributions from your 401(k), you will have to pay taxes on the amounts you receive.
A Roth 401(k) works in reverse.
You pay taxes on the money you contribute now, however, when you withdraw funds in retirement you do not have to pay taxes. For example, if you contribute $1,500 to your 401(k) this year, when you file your tax return for the year, the $1,500 will be included as income. However, when you are in retirement and you start taking distributions from your 401(k), you will not have to pay taxes on the amounts you receive.
The earlier you start contributing to a 401(k) the more prepared you will be for retirement. Even if you have to start small, it is usually best to start.
Read the article below, “Understanding Your 401(k)”, to find the answers to 10 frequently asked questions about your 401(k).