What is a 401(k) Retirement Plan? | ModMoney

What is a 401(k) Retirement Plan?

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Saving for retirement can be a daunting and faraway concept for a young professional. We're all navigating through busy lives and more immediate obligations, so who wants to think decades ahead? The reality is that it's important to start saving early so we can let our money grow with time. And a 401(k) plan is an excellent place to start!

But what is a 401(k)? And do you even need one? (Hint: probably). Read on for everything you need to know about a 401(k) retirement plan.

1. Opening a 401(k) Plan

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 a 401(k) is if your employer offers it as part of your employee benefits package. Once your account is open, adding money to your 401(k) is pretty straightforward and low-maintenance. When you decide how much you want to contribute, your employer will automatically deduct it from your paycheck each month. Easy!

2. 401(k) 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's an 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. 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. Plus, if I believe my tax rate in retirement will be lower than it is today, it makes even more sense to delay paying taxes.

3. 401(k) Employer Match

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, bump your retirement contributions at least in line with what your employer will match.

4. How to Invest Y your 401(k)

Once you make a contribution, what do you do with the dollars 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. You can invest your 401(k) money into stocks, bonds, mutual funds, and a variety of other asset classes. Each 401(k) plan will have different investment options, so you’ll want to check with yours 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 take a riskier approach. As you age, you’ll want to shift some of those riskier assets into safer bets that won’t be negatively impacted by market volatility.

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5. 401(k) 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. For every dollar you contribute, that’s tax money the government has to wait years to receive. For 2018, the limit is $18,500, 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

Scenario: You can't access your 401(k) savings for a few decades, but you want to make a down payment on a new home and a new car in the next couple of years. Plus, you want to pay down your student loans ASAP! So what do you do? It's important 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.

The Bottom Line

A 401(k) is a great option for retirement saving because of employer matching and the ability to defer your tax payments. If you have the means to do so, 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. Because you can't access your retirement savings until...well...retirement!

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