A tax-advantaged investment plan called a 401(k) enables you to put some of your paycheck into the account. Your employer may match your contributions, and you can choose from various investment options, including low-cost funds. Checked the fees associated with each fund to ensure they were reasonable. You also might consider a target date fund, which adjusts your portfolio to become more conservative as you approach retirement.
401(k)s allow you to grow money for retirement without paying income taxes on it until you withdraw it in retirement. That’s a huge benefit. In addition, 401(k) plans often offer attractive investments. You’ll find many options, including stocks and stock funds, bond funds and so-called target date funds that adjust your portfolio to a more conservative one as you near retirement.
The amount of money that grows in your 401(k) depends on how much you contribute, the investments you select and how long you remain invested before retirement. That’s why it’s important to invest wisely and to keep your 401(k) contributions in line with your overall financial plan. Depending on your employer’s plan, you can get free matches from your company and other incentives such as profit-sharing. You’ll also be able to defer pre-tax dollars instead of after-tax dollars, which can lower your tax bill for the year. If your employer doesn’t offer a 401(k) or you’re looking for alternatives, consider investing in an individual retirement account (IRA), Roth IRA or health savings account.
Tax-Free Withdrawals in Retirement
The 401k plan benefits are a powerful draw for many investors. Pre-tax contributions are accepted in a typical 401(k), and profits accumulate tax-deferred until withdrawals are made in retirement; at this point, they are subject to ordinary income taxes. Your distributions from a Roth 401(k) are tax-free. If you anticipate being in a lower income tax rate in retirement than you are now when you make your contributions, this possibility of tax-free retirement withdrawal is very advantageous.
In addition, having money spread out in both pre-tax and post-tax accounts gives ‘future you’ flexibility to better control your tax bracket in retirement. For example, if you withdraw too much in retirement from only a pre-tax account, your Social Security payments could be affected, and you’ll be subject to Medicare surcharges if you exceed certain income thresholds. A mix of funds can help you avoid this risk. It can be especially important for early retirees with shorter working lives, and must be careful with withdrawals.
Employers can encourage employees to save by matching some of their contributions. For example, a company may offer a dollar-for-dollar match on up to 3 percent of an employee’s salary. That effectively doubles the amount of money saved, assuming no increase in investment returns. Some companies also add a profit-sharing feature that contributes a portion of the employer’s profits to the plan. These additional contributions are made pre-tax, which can dramatically increase the savings potential. The employer’s contribution is typically invested in the same investments as the employee, allowing the opportunity to leverage the power of compounding by investing that money. Many employers also provide a selection of model portfolios or target-date funds designed to reduce risk as an investor approaches retirement.
Ultimately, a 401k investment’s value depends on how much is saved, the returns earned, and the number of years left until retirement. That’s why financial experts typically recommend that employees invest at least enough to maximize their employer’s matching contribution. After that, they should focus on paying off high-interest debt and building an emergency fund before saving more in their 401k or other tax-advantaged accounts.
Stowing away savings in a 401(k) or similar workplace retirement account regularly is a powerful ally when investing for your future. Even with limited funds, investing can help your money grow faster, thanks to compounding. Compounding is when your interest earnings are plowed back into your principal investments, so you earn more on the original amount and accumulated interest. Over time, this can have exponential results. One way to harness the power of compounding is by automatically investing your paycheck or other income sources into your 401(k), IRA, or similar account through payroll deductions or automated bank withdrawals. It makes it simpler to stick with a long-term investing strategy and helps you resist the need to divert your investment funds.
The 401k plan is the most popular defined contribution (DC) employer-sponsored retirement account in the United States. It is modeled after Internal Revenue Code Section 401(k), enabling qualified employees to set aside a portion of their take-home pay before taxes. Employers may match contributions to the plan. Many 401k plans come with a menu of investment options. These could include mutual funds, company stocks, index funds, stable value (or cash) funds, bond funds and so-called target date funds that adjust the mix of investments over time to align with an investor’s retirement horizon. Although all investments carry risks, a diversified portfolio can help protect your savings from big losses. And over the long term, stocks have generally returned a higher rate of return than other investments. Thanks to compounding, earnings from investments are reinvested in the same investments – earning interest on those earnings over time. It can help your money grow faster than if you left it in a bank account.