401(k)

What is it?

How does it work?

       A 401(k) (A TSP for government employees) is an employer-sponsored retirement savings plan. Often offered as part of a job benefits package, employees may save a portion of their salary in a 401(k) account (subject to annual limitations). Employers often match a portion of their employees’ contributions. Meaning if you put in 3% of your salary, they will match that 3% amount dollar for dollar (Most go up to 3% match DFD). It is wise to contribute the maximum amount your company matches because it is essentially free money.

       A 401(k) provides you with a tax break when you save a portion of your salary for retirement. When you sign up for your employer’s 401(k) plan, you agree to have a percentage of each paycheck deposited directly into your personal 401(k) account. You can choose different investments with the saved money, but it is usually put into mutual funds (Pools money from many investors then invests it), Index funds, or ETFs (Funds traded that usually track an index).

Traditional and Roth

Traditional 401(K) contributions are taken directly out of your paycheck before income taxes, meaning your taxable income is lowered immediately. However, you pay ordinary income tax on your withdrawals. 

Roth 401(k) contributions are taken after you pay income taxes with no tax break like the traditional. However, similar to the Roth IRA, you pay no taxes on qualified distributions. This option is generally better if you believe you will be in a higher tax bracket when you retire than you are now.

Contributions

You can contribute however much you want into a 401(k) every year subject to IRS limitations.

Let’s say your monthly paycheck is $4,000, and you chose to contribute 5% of your annual salary in the company’s traditional 401(k) plan. In this case, $200 would be subtracted from each paycheck and deposited in your account. Your taxable income would be $3,800 (assuming no other pre-tax deductions). If you opted for a Roth 401(k), the $200 would be taken out of each paycheck after taxes.

Depending on your employer’s plan, you may be automatically opted into a 401(k) plan at a set contribution rate when you start a job (unless you choose to opt-out). Alternatively, you may need to agree to a plan before being provided one

What to Invest In

You can choose to invest in a wide variety of stocks, bonds, and funds for your account. You can opt to have a financial advisor run your account or can choose to have more control. 

Ex. You can tell your employer you want to invest 60% of the balance in Mutual Funds, 30% in Index Funds, and 10% in a bond index fund. 

Some companies automatically make a portfolio and base it on a few factors such as income, age, and tolerance. A younger kid would be put more into stocks because even though they are riskier they have a higher chance for a big return. Younger workers also have time to make more money, while older workers do not have time for risk and therefore are more invested in index funds and things of that nature.

Withdrawals 

A 401(k) is meant to provide you with an income during retirement, so taking money out cannot be done until after 59 1/2 without huge penalties (around 25-30% tax). There are a few exceptions though, such as medical expenses, military reasons, or a disability.

If you are going through different withdrawals for your 401(k), I suggest a financial advisor or therapist.