5 Things to Know About Your 401(k) | ModMoney

5 Things You Need to Know About Your 401(k)

Saving for retirement can be a daunting and seemingly faraway concept for a recent college grad or young professional. After all, we're all navigating through busy lives and other more immediate financial obligations. Still, it's important to start saving early (here is the reason why), and a retirement account like a 401(k) is a great vehicle to save into. This post boils down the 5 things you need to understand about your 401(k) so you can effectively save for your future AND prepare for near-term obligations. Like paying off those student loans. Or making a down payment on that dream house. Or buying that new car. You get it.

1. The 401(k)

A 401(k) is the most popular employer-sponsored retirement plan, so most of us are at least familiar with it. The only way to open one is if your employer offers it as part of your employee benefits package. Funding your account is pretty straightforward and low-maintenance. Once you decide how much you want to contribute, your employer will automatically deduct it from your paycheck each month. Easy!

2. Tax Benefits

One of the most important things to understand about a 401(k) is that it entitles you to tax deductions. Stick with me – I’ll explain! When you contribute some of your income to a 401(k), you don’t have to pay taxes on that income until you withdraw it in retirement. Here is a simple example. Let’s say I make $50,000 one year and contribute $10,000 of it to my 401(k). In this case, I would only have to pay taxes on $40,000 that year. So not only am I putting a good chunk away for retirement and allowing my savings to compound, but I’m also reducing my taxable income in that year. Plus, if I believe that my tax rate in retirement will be lower than my tax rate today, it makes even more sense to delay paying these taxes.

3. Employer Matching

Another advantage of a 401(k) is that most employers will match your contributions dollar for dollar up to a certain amount. This amount can vary but will often fall in the range of 3% and 5% of your salary. I like to think of this as free money, but there is a catch. Let’s say my employer is willing to match 5% of my salary, but I only contribute 3%. In that case, my employer will only match the 3%, and I’m leaving money on the table. So, if you have the means to do it, it’s a good idea to bump your retirement contributions at least in line with what your employer will match.

4. Investing

Once you make a contribution, what do you do with the dollars that are now sitting in your account? Many people get confused and believe that the 401(k) itself is the investment. In reality, you can think of your 401(k) as a basket that holds your investments. Going back to my prior example, after I contribute $10,000 to my 401(k), I can invest that money into stocks, bonds, mutual funds, etc. Each 401(k) plan will have different investment options, so you’ll want to check with yours specifically to see your choices. Your age and risk profile will impact the ratio of your investment in riskier assets (like stocks) and safer assets (like bonds). As a young person with many years before retirement, you can afford to withstand some fluctuation in the markets and can therefore take a riskier approach. As you get older and closer to retirement, you’ll want to shift some of those riskier assets into safer bets that won’t be negatively impacted by market volatility.

5. Restrictions

A 401(k) comes with some restrictions. For one, the federal government limits the amount you can contribute in any given year. Think about it – it makes sense! For every dollar you contribute, that’s tax money the government has to wait years to receive. For 2016, the limit is $18,000, but it changes annually.

Additionally, you can’t start withdrawing from your 401(k) until you reach the age of 59 1/2 without incurring penalties. Because of this restriction, it’s important to find the right balance between your retirement savings and the savings you can access today.

Saving for Retirement vs. Today

So you can't access your 401(k) savings for a few decades. But you know that you want to make a down payment on a new home and a new car in the next couple of years. With this foresight, you need to make sure that your retirement contributions are leaving room for you to save money that you can access sooner than age 59 1/2.

Also, it's important to prioritize paying off any debt with interest rates higher than 6-8%, which is what you can expect to earn long-term in the stock market. Said differently, let's say you have credit card debt charging you 15% interest. It would make sense to pay off this expensive debt first, since what you are spending in interest likely exceeds what you will make in the stock market long-term.

The Bottom Line

The bottom line is that a 401(k) is a great option for retirement saving, largely because of employer matching and the ability to defer your tax payments. If you have the means to do so, it’s a great idea to contribute at least as much as your employer will match, since it's essentially a salary bump! However, make sure that you have enough saved up outside of your 401(k) to meet short-term obligations, since you can't access your retirement savings until, well, retirement!

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