While retirement may seem light-years away, any seasoned financial professional will tell you that planning for your golden years should start as early as possible. Although it can be hard to think so far ahead, your company may help you prepare for the future by offering a 401(k) plan.
A 401(k) plan is a retirement savings plan that is often part of a company’s benefits package. This plan enables you to divert money from your paycheck to an investment account. In addition to your personal contribution, many companies will also put money into your 401(k) plan, “matching” a portion of your allocation.
Usually, there will be a pre-set amount diverted from your paycheck; however, you can alter how much you want to put into your 401(k) plan. You may choose to dial the amount up or down depending on your financial situation and the company’s offerings. For example, if your employer matches exactly what you put in and you are financially stable, you may wish to contribute as much as you can to your 401(k) plan.
Understanding your company’s 401(k) plan is the first step to making the most of it.
Discover What Plan(s) Your Company Offers
Traditional Pre-Tax 401(k)
With a traditional 401(k) plan, you save on taxes in two ways. First, since your reported salary is reduced by the amount put into your account, you’ll pay less income tax. Second, you don’t pay tax on the gains made each year in your account; the tax is deferred until withdrawal. So, you’ll only pay tax on the amount you withdraw during your retirement.
In a Roth 401(k) plan, contributions are made with after-tax dollars, and you do not pay taxes on the amount you withdraw during your retirement. Compared to a traditional 401(k) plan, a Roth plan allows you to save on future tax rather than current tax. With this plan, you do not reduce your earned income by the amount contributed to your account. However, your account will grow in a tax-free manner, and you’ll be able to withdraw money tax-free during your retirement.
For the tax year 2022, the contribution limit will be $20,500 per individual. If you have multiple plans, the combined contributions are capped at $20,500.1
Choosing the Right 401(k) Plan for Your Situation
If your employer offers both a traditional pre-tax 401(k) plan and a Roth 401(k) plan, you’ll have to decide which plan is right for you. Remember, in a traditional pre-tax 401(k) plan, you’ll pay tax when withdrawing, and in a Roth 401(k) plan, you’ll pay tax on your contributions. This difference will be a factor when you are choosing the best plan for your situation. Then, during the later stages of your career, when your salary and tax rate are higher, you may prefer to make pre-tax contributions to a traditional 401(k) plan.
Should You Also Open an IRA?
Aside from your employer’s 401(k) plan, you have the option to open an individual retirement account (IRA). This may be a wise option for those who are in the early stages of their career with an employer that only offers traditional 401(k) plans. In this scenario, opening a Roth IRA would enable you to make after-tax contributions at a time in your life when you have a lower tax rate.
Understand Your Investment Options
Many plans will allow you to choose between multiple types of investments, such as different mutual funds. Thoroughly explore these options and consider which one best fits your circumstances.
Is Your Employer Contributing to Your 401(k)?
In many scenarios, your employer will also contribute to your 401(k) plan. These contributions are pre-tax, so you’ll only pay taxes on the money when you withdraw it during your retirement. There are several types of employer contributions: matching, non-elective, and profit-sharing.
With a matching employer contribution, your employer contributes the same amount as you. Sometimes there is a minimum amount that you must contribute before the employer will contribute. In such cases, some people decide to contribute at least the minimum so that they qualify for the matching contribution.
A non-elective employer contribution means that your employer will put in the same percentage for every employee, even if the employee is not contributing.
In a profit-sharing 401(k) plan, employers delegate a percentage or dollar amount of the company’s profit to employees’ 401(k) accounts.
Find Out When Your Employer Contribution Dollars Are Yours
Frequently, an employee can only keep his or her employer’s contributions after they have worked for a certain number of years in the company, otherwise known as “vesting.” When you’re vested after a certain number of years, you own the contributions made by your employer.
If you want to make the most of your employer’s plan, find out the length of time it takes to become vested. You may decide to part ways with the company only after you are vested, which would allow you to take full advantage of your company’s 401(k) plan.
Once you understand the specifics of your company’s 401(k) offerings, you’ll be able to make the most of the plan and use it to meet your needs and goals.
This content is developed from sources believed to be providing accurate information, and provided by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.