401ks are a topic often briefly discussed, and normally given to you in a dense packet when you first join a company. However, it’s an important topic especially since everyone at one point will eventually retire. That is why we have decided to offer you some basic information on them so you can get started.

What is a 401k?

A 401k is a retirement plan offered by employers in which an employee contributes a percentage of their salary, through payroll deductions, to a sponsored retirement savings account. The employee can normally increase or decrease their contributions at anytime. The money that you contribute is pre-tax, meaning that the money gets put into your account and the government can’t tax it until you take it out and start using it as income during your retirement. Once the money is put into your retirement account, it grows based on the mutual fund investment you choose or is designated to you by your employer.

Company Matching

Based on your company’s policy, they will match the amount of money you place into your 401k up to a certain percentage. For instance, let’s say you had a salary of $50,000 and your company matches up to 3% of your salary. If you put $1,500 into your retirement account which is 3%, they would match that $1,500, and you would end up with $3,000 saved in your retirement account for that year. However, if you put 4% which is $2,000, they would still give you $1,500. Finally, if you put 2% which is $1,000, they would only give you $1,000 instead of the $1,500 that you could have gotten if you had put in 3%. Either way this is an excellent way to increase the amount of money saved in your retirement account.

Vesting

Vesting is when a company requires that you wait a few years before you can gain the full rights of their matching contributions to your retirement account. Meaning if they contributed $4,500 to your account for 3 years, and they require for you to stay with them for 4 years, you do not own that $4,500, plus the money they contributed for the 4th year until you reach your 4th year of employment. However, if you quit before the 4th year, you will not get to keep the $4,500 but you will get to keep the money that you invested. Essentially this is a way for the company to keep you with them for a certain period of time.

Withdrawal Rules

The money in your 401k must be kept there until you are 59 ½. If you take any of the money before then, it will result in a 10% early withdrawal penalty, and you will still have to pay the income tax on the funds withdrawn. There are however circumstances that you are allowed to withdraw this money without penalty. Every plan differs but you can take it out of a retirement account before the required age if you use it for:

  • Buying your first home
  • Costs after the onset of a sudden disability
  • Higher education expenses like paying for your child’s college
  • Payments to prevent eviction or a foreclosure

          (“How does a 401(k) plan work?”, 2015).

However, you don’t want to rely on your 401k for immediate financial needs because you will be taking away from your financial security in the future.

Changing Employers

If you end up leaving your company, there are many options available to you in regards to your  401k. These include:

  • Rolling over your account balance into your new employer’s plan.
  • Rolling over your account balance into an Individual Retirement Account (IRA).
  • Based on your company’s policy, you may be able to leave your balance in its plan.
  • Withdraw your account balance in a lump sum cash payout. However, with this option  you will not only reduce your retirement savings, but also face severe tax consequences.  (“What is a 401(k) plan?”, 2015)

Calculating Your Retirement Goals

The first thing you want to do is contribute enough to get a full match from your employer. This will serve as a good base for your overall retirement plan. Once you have this settled, the next step is to figure out how much you believe you will need to save in order to live how you would like to live during retirement, and for how long you plan on being in retirement. There are many ways to come up with this number.

One way of doings this is to assume that you would like the same standard of living that you currently have. In this case the rule of thumb is that you will need at minimum 80% of your current income or even better 85% (Weliver, 2014). Let’s say someone is 26, and they make $60,000 a year. Based on our 85% rule they figure they will live off of $51,000 per year. They plan to retire at age 65 and will live until they are 93 so $51,000 * 28 = $1,428,000. Another way to figure out your goal is to use a calculator such as this calculator created by CNN or this more complicated calculator created by Merrill Edge. They will help you figure out how much you need based on your age, how much you have saved, when you plan on retiring, and your investment strategy. Once you make your calculation,  you should check your calculations yearly to make sure that you are on track.

Investment Strategies

In terms of investing in your retirement you will often have a few different strategies to take. The first one is “defensive investing.” Defensive investing protects your investment portfolio from taking too many losses but you will also not gain as much as other investment strategies. This strategy is suitable for someone who will need their retirement money sooner rather than later.

The second strategy is a “balanced investment.” This method is for those who would like a balanced risk with their money, by having less losses than an aggressive strategy and more gains than an defensive strategy. This strategy is for someone who still has a good amount of time before they retire.

The third investment strategy is the “aggressive investment” strategy. This strategy is meant to get the maximum amount of money you can get by risking a large amount of potential loss. Aggressive investment strategies are especially suitable for those who are young because they still have a longer time before retirement, and can stomach the loss they could potentially incur.

The final strategy isn’t much of a strategy but an option that companies often offer which is the target age mutual fund. Basically you are placed into a target age of when the people your age generally retire, and the strategy of investment is taken care of for you because the mutual fund changes strategy from aggressive to defensive as you get older.

401ks are the cornerstone of your retirement strategy and the earlier you start thinking about it, and using it, the better off you’ll be when you retire. Hopefully, the knowledge that was offered here will give you a good place to start.

 

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This blog post is provided for discussion purposes, and is not intended as professional financial advice. It’s intent is not to be used as the sole basis for your investment or tax planning decisions. To get more information please speak with a financial planner. Under no circumstances does this information represent a recommendation to buy or sell securities.

References:

How does a 401(k) plan work? (n.d.). Retrieved November 21, 2015, from http://money.cnn.com/retirement/guide/401k_401kplans.moneymag/

Weliver, D. (2014, August 1). How Much Should You Contribute To Your 401(k)? Retrieved November 19, 2015, from http://www.moneyunder30.com/how-much-should-you-contribute-to-your-401k

What is a 401(k) plan? (n.d.). Retrieved November 24, 2015, from http://www.practicalmoneyskills.com/personalfinance/lifeevents/benefits/401k.php