For those of you in your first job one of the things HR hands you is a 401(k) Retirement Packet. (If you are in a job that gives you a pension when you retire, consider yourself blessed. I’ll explain later.) In this packet there are all kinds of info about contributions, rollovers, withdrawals etc. This post will explain what you need to know and how to maximize this benefit.
The 401(k) gets its name after a section in the Internal Revenue Code established in the Revenue Act of 1978. It’s a way to defer income for retirement plans. A 401(k) is a great way to save for retirement because it uses your “pre-tax” income to invest in a fund of your choosing. The fund grows tax-free until retirement. At retirement withdrawals will be taxed as regular income. Many employers will match an employee’s contribution, 1-5% of your salary, adding to your fund.
How much to contribute?
The maximum employee annual contribution, as of 2016, is 25% of your salary up to $18,000. My first employer, BIG RETAIL, started me off at 1% as a default. Unfortunately I didn’t notice this for a month or two because that is way too low. I recommend that a person in their first job should contribute 25% if they live at home and 15% if they do not. The more you contribute at the beginning, the more time your money will grow. It will also teach you how to live within your means at a young age and budget appropriately.
Types of funds
Generally these are mutual funds that have specific goals (Growth, Income, Target Date). You would need to choose a fund based on your risk aversion. Investing in stock-based funds at a young age this is a typical option at generating growth. Funds that are mostly bonds and cash are more stable (less risky) but offer smaller growth. I am currently in a Target Fund, which means that it’s based on the year I plan to retire and adjusts its holdings as time goes on. I will probably making changes as time goes on.
The “pre-tax” dollars that you contribute to the fund comes out of your paycheck before taxes are taken. The contribution lowers your income but also lowers the amount of taxes that you pay. If you put $500 into your 401(k) each month, your paycheck might only be smaller by about $300-$400 per month. The amount will vary depending on your salary, tax bracket and location.
Rollovers & Vesting
When I left BIG RETAIL the first thing I did was learn about my new company’s, BIG NEWS, 401(k) rollover policy. A rollover is when you move your money from one plan to another. Some plans do not allow rollovers, but thankfully mine did. I was able to move all of it into my new account without an issue. I was fully vested at BIG RETAIL and did not miss out on any of the company match money. Money that you contribute from your paycheck is always yours. But company-matching funds vest over time; usually over several years. Once you’re fully vested, you can take the entire company match with you when leaving your job. If you’re not fully vested, you’ll get to keep only a portion of the match or maybe none at all. Check with your company’s benefits administrator.
The earliest you can withdraw from your account without a penalty is at age 59½. If you withdraw any of it before then you will be assessed a 10% early withdrawal penalty, and will still have to pay regular income tax that is due. Yikes! There are some exceptions, however. The IRS waives the 10% penalty for certain “hardship” withdrawals. Each plan’s rules vary, so check yours to be sure. To be honest I think the 59½ age minimum will increase because the government wants us to work and pay higher taxes. I also believe Social Security will be changed this way too.
Many plans allow you to borrow from your account. You must repay the money back within a few years or the loan is treated as a withdrawal, meaning you’ll owe taxes and a 10% penalty on it. Try not to do this!!! You will reduce your growth, pay interest on the loan and if you get laid off or change jobs you must pay the loan back within a few months.
My Dad had a pension when he retired. He never worried about the stock market or the S&P. I’m now envious of him because he knew exactly how much he was going to be making when he retired. To put into context, a person retiring now with a $50,000 a year pension is akin to someone else retiring with a $1,500,000 401K balance. This is based on 30 years of life after retirement. So if you want to live like a pensioner, then contributing and actively managing your 401(k) account is a must.
- Contribute as much as you can & remain consistent
- Learn about all of the funds that are offered and choose the right one for you
- Do not borrow or withdraw early
- Look at your account monthly and see what trends are going on in your fund
- Speak to a fund manager if you have any concerns
This might be a bit overwhelming but hang in there, there is plenty of great things and experiences to look forward to.
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