Whether you’re just starting your career or you’re further along in your professional journey, you may have had the opportunity to invest in a 401(k) through your employer. These investment plans provide a tax-advantaged way to save for retirement and, in some cases, your employer may even make extra contributions on your behalf. But what exactly is a 401(k), and how can you take full advantage of one?
What is a 401(k) Plan?
A 401(k) plan is an employer-sponsored defined contribution plan which employees can contribute a portion of their salary to. Within this account, you can invest in a variety of securities – as determined by your employer – to potentially grow your savings over time. In the case of a traditional 401(k), any contributions you make are deducted from your paycheck before taxes are applied, which can help lower your taxes each pay period. Investments made with those contributions are allowed to grow on a tax-deferred basis within the account. You’re then required to pay income taxes on withdrawals you make from the account.
Roth 401(k)
As an alternative to a traditional 401(k) plan, some employers may offer a Roth 401(k). In this plan, your contributions are made with post-tax dollars, but you may be able to withdraw funds tax-free in retirement assuming you meet certain requirements, including:
● It must have been at least five years since you first contributed to the account
● In most cases, you must be at least 59.5 years old
Roth contributions – not the investment returns earned on those contributions – can be withdrawn at any time for any reason. Additionally, you may be able to draw from the account to cover certain qualifying expenses, such as a first-time home purchase. Due to the tax treatments surrounding Roth 401(k)s, it may be a good fit for those who expect to be in a higher tax bracket in retirement and may not benefit as much from lowering their taxable income today. You may be able to make contributions to a traditional 401(k) and a Roth 401(k) if your employer offers both, although they share an annual contribution limit.
403(b) Plan
Similar to 401(k)s, a 403(b) plan is a tax-advantaged retirement account designed for employees who work at public schools or other tax-exempt organizations, such as non-profits. These plans can also come in traditional and Roth models with their respective tax rules. Like a 401(k), 403(b) plans are subject to income restrictions.
Contributing to Your 401(k)
Generally speaking, when you begin a job, you decide how much of your salary to contribute to the company’s 401(k). For instance, if your paycheck is $3,000 and you choose to deposit 5%, then $150 is subtracted before taxes. That means your taxable income becomes $2,850.
Before you start contributing to your 401(k) plan, it’s important to understand how the account works first. For instance, the IRS places limitations on the amount that can be contributed to these retirement accounts each year. Those over 50 years old have a higher annual contribution limit, called a “catch-up” contribution.
Some employers may provide a match for your contributions, often up to a certain
percentage of your salary. If your employer offers a 401(k) match program, you should consider taking full advantage of it – otherwise, you’re leaving money on the table.
Your 401(k) plan may allow you to borrow from your account balance, although it’s generally advised not to do so unless it becomes absolutely necessary. Note that if you don’t repay the loan, including interest, unpaid amounts could become a plan distribution.
Choosing 401(k) Investment Options
Once you’ve opened a 401(k) account with your employer, you’ll typically have several investment options provided by the plan administrator. These can include things like bonds, mutual funds, index funds, and even exchange traded funds in
some instances. However, options vary widely depending on your employer, and knowing which to choose isn’t always obvious.
A financial advisor can help you make the right investment decisions in your 401(k) plan and beyond. If you’d like guidance on what works best within your financial plan, consider connecting with a financial advisor today.
Best,
Robert (Rory) J. O’Hara III, CFP®, CRPC®
Founder I Senior Managing Partner
