Updated: Oct 29, 2021
401(k) plans are a widely known and used retirement investment option across the country. Despite the fact that more firms are providing 401(k) plans as a perk to their employees, the Economic Policy Institute discovered that just half of American families had any retirement savings at all. Every dollar matters when it comes to retirement savings, and the transition from work to retirement isn't a simple one.
So, what is a 401(k) plan? Should you take advantage of the plan that has been given to you? And how can you maximize your contributions? If you're one of the millions of individuals struggling to save for retirement, explore this article to learn how your employer's 401(k) plan can help you plan for retirement and how to participate in it effectively.
What is a 401(k)?
Many businesses provide a 401(k)-retirement plan to assist their workers in saving for retirement. A 401(k) plan allows members to save for retirement by making pre-tax contributions through payroll deductions. The IRS maximum for 2021 is $19,500; therefore, most plans will enable members to contribute up to 100% of their earnings. If the plan allows for catch-up contributions, members over 50 may be eligible to contribute an extra $6,500 in 2021. Many firms also contribute to employee accounts with matching employer payments or profit-sharing contributions. Participants in most plans have the option of directing their contributions to a variety of investment options. A 401(k) plan may also provide additional advantages, including creditor protection, loan options, and more. However, because plans differ, you must consult your specific plan benefits to understand what options are available.
Withdrawing From Your 401(k)
You shouldn't take money out of your 401(k) account until you're 59 1/2 years old. You can do it if you have to, but you'll have to pay heavy penalties or interest if you wish to borrow against your account's worth. When you eventually take funds from your 401(k), you must pay income taxes. For this reason, most people profit from their 401(k) contributions because they are taxed at a lower rate in retirement than they were when they were working.
The Difference Between a Traditional and Roth Account
The primary distinction between a traditional and a Roth 401(k) is when taxes are paid. Contributions to a traditional 401(k) are made using pre-tax money, so you get a tax break right away, which helps to decrease your current income tax payment. Your money grows tax-deferred until you withdraw it, both contributions and profits. Withdrawals are treated as regular income at that time, and you must pay your current tax rate. Furthermore, if you're under 59½, you may be subject to a 10% penalty in certain instances.
It's the exact opposite with a Roth 401(k). You contribute after-tax dollars, which means you don't get a tax deduction right away. However, at the age of 59½, however, withdrawals of both contributions and earnings are tax-free if you've had the account for five years.
So, deciding which type is right for you is primarily a question of whether it's better to pay your taxes now or later. This is highly dependent on your retirement timeframe as well as what your career future may hold.
6 Ways to Maximize Your 401(k) Contributions
Up to this point, we have covered the basics of what a 401(k) is, how withdraws work, and the difference between the two basic types. Now it’s time to start thinking about ways you can maximize your contributions to your 401(k) account. Below are five practices you can start working on today!
1. Consider Your Risk Tolerance
Before you start investing in anything, especially 401(k)’s, you need to understand how much risk you are willing and able to take. Risk tolerance isn’t just your attitude towards investing, though that does play a role. Instead, when evaluating your risk tolerance, you should consider numerous things like your investment goals and experience, how much time you have to invest, and your other financial resources. Understanding your risk can help you create an intelligent investment plan and aid in the success of your investments, especially with a 401(k).
2. Consider Your Age
Along with risk tolerance, your age should play a significant role in determining what and how much you invest in. In general, the younger you are, the riskier your investment portfolio can be. The reasoning for this is because the younger a person is, the more time they have to recover any losses incurred due to events such as a market collapse. Someone who is a few years away from retirement, on the other hand, will not have the time to recover from a market downturn.
One of the most accurate ways to assess the proper ratio of stocks to bonds for investors is to take a risk capacity survey or seek the assistance of an experienced financial advisor.
3. Determine How Much Do You Need to Retire
Many financial experts recommend having enough money set aside for retirement and other sources of income, such as social security or a pension, to replace 80 percent of your salary before retiring. Once you determine how much money you will need during your retirement years, you need to select the percentage of return you will need from your 401(k) to aid in building your retirement fund. In doing this, you should use a conservative estimate of 5–7% yearly returns from your 401(k) to figure out what kind of balance you'll need to produce the extra income. However, if you’re struggling to determine this by yourself, you may want to look into another approach. For example, you could take advantage of a retirement calculator or speak with an experienced financial advisor.
4. Remember Fee’s Involved
A 401(k) plan is costly to operate, and the fees are usually deducted from your investment profits. You won't be able to avoid all of your 401(k) plan's fees and charges as they are established by the agreement your employer made with the plan's financial services provider. However, you may be able to minimize some of them.
Your 401(k) operation generates two types of bills: plan expenses, which you can't avoid, and fund fees, which are dependent on the investments you pick. Plan expenses cover the administrative costs of running the retirement plan, such as keeping track of contributions and members. Fund fees include things such as trading commissions and pay for a portfolio manager. So, to keep down your expenses, try to avoid funds that have the highest management and sales costs among your options.
One last point that you should know is the Department of Labor has laws that require employees to be told about fees and charges so that they may make educated investment decisions, so make use of this information.
5. Take Advantage of Employer Match, If Available
Company matching of 401(k) contributions implies that your employer matches a portion of your annual contribution to your retirement savings plan. Your contributions to your retirement savings may be matched by employer contributions in a variety of ways, depending on the conditions of your employer's 401(k) plan. Employers often match a proportion of employee contributions up to a specific percentage of overall compensation. Employers may occasionally choose to match employee contributions up to a particular cash level, independent of employee pay.
If your employer matches your contributions, it means they’re essentially giving you free money when you participate in your 401(k) plan. So, be sure to take advantage of this and try to contribute at least the amount that qualifies you for the entire match from your employer.
6. How to Pick Your Funds
After you've started contributing to a 401(k), you'll need to decide which investments to acquire. Your money will otherwise be held in a money market account. A 401(k) plan often does not allow you to invest in individual companies. Instead, you'll invest in a range of firms and sectors through one or more mutual funds or exchange-traded funds. Although the financial market offers hundreds of funds, your company's 401(k) plan will only likely provide a limited number of stock and bond funds, ranging from conservative to aggressive.
When deciding what funds to invest in, put in the time to research your options. Be sure to pay close attention to the fees of the fund, the holdings, and its allocation. Furthermore, you’ll want to ensure your investments are diverse and spread across various market sectors. Remember, if you’re still unsure after doing your research, you can always work with an outside professional financial advisor to select the best 401(k) investments for you!
What If My Employer Does Not Offer a 401(k) Plan?
Many individuals utilize 401(k)s to save for retirement, which is why you hear a lot about them. However, more than a third of working adults do not have access to a 401(k) plan via their employer. If you’re in that situation, you can still use other accounts to build up your retirement instead. Such options that may be available to you include:
Individual Retirement Accounts
Taxable Investment Accounts
Tax-Advantaged Retirement Accounts
Simplified Employee Pensions Individual Retirement Account
Schedule A Consultation with an Experienced Financial Advisor
Whether you're just getting started with your 401(k) or have had one for years seeking guidance from an experienced financial advisor can still be very beneficial to you. A financial advisor can aid you in navigating your options and design a strategy to accomplish your retirement goals, no matter how far away that date may be.
Here at Fourth Avenue Financial, our advisor's first priority is your overall financial success. Our experienced financial advisors have helped clients with many different circumstances in their 401(k) needs, and we are ready to help you develop, implement, and monitor a strategy that's designed to address your individual situation. If you are ready to start planning for your financial future, we are here to help. Contact us today at (304) 746 7977 to schedule a meeting with one of our experienced financial advisors or schedule online: https://calendly.com/fourthavenuefinancial/introductory-zoom.