A traditional 401k plan is one of the easiest ways to start saving for retirement. Upon starting a new job, an employee may be automatically enrolled in a 401k plan while others may have a probation period before starting to contribute. In most cases, an employee will need to choose a fixed percentage of their wages out of every paycheck that they want to contribute to their 401k. These contributions are pre-tax income, meaning that the amount goes into the 401k before income taxes are applied.
The big benefit is that 401k contributions reduce your yearly income, thereby reducing your taxes. Additionally, the 401k grows tax deferred, meaning no taxes are paid until the money is distributed (ideally in retirement). An employee will also need to choose in which investments to put their money as well as what portion of the contribution they want distributed into each investment. Finally, an employer can match an employee’s contributions, helping the employee maximize their money.
What are the benefits of getting started early?
The obvious benefit of starting early with a traditional 401k is that the more time it has, the more it will grow. The principal will grow with interest, but you also have the benefit of compound interest, or earning interest on your interest plus the principal amount. And in today’s economy, you’ll most likely change jobs over your career. The good news is that you can take your earnings with you, rolling over your traditional 401k account into the next.
You do need to consider the possible tax bracket you’ll be in by retirement. If you think you’ll be in a lower tax bracket, distributions from your traditional 401k could bump you into a higher tax bracket, since those distributions will be considered taxable income. This could make you pay more taxes, including on Social Security. In this case, a Roth 401k may be a good option.
How to maximize employer matching
Not taking advantage of a traditional 401k with employer matching is like leaving free money on the table. Employers commonly match employee contributions dollar-for-dollar up to 3% of the employee’s salary. Or they can also match $.50 to every dollar an employee contributes up to 5%. Some generous employers even match 100% of an employee’s contribution up to a certain percentage of their salary.
You’ll want to check what formula your employer offers, and contribute the amount that will maximize your employer’s match. Your employer may also require you to follow a vesting schedule, meaning that you need to work at the company for several years before taking ownership over their contributions.
What are your investment choices?
The plan administrator will provide several options for investment: different mutual funds, index funds, and exchange traded funds. You can choose to divide your contribution into different funds. If you’re automatically enrolled in a 401k plan, your contributions will most likely go into a target-date fund. This is a fund that has a mix of stocks and bonds, and is invested according to your age and “target-date” of retirement. However, you can always change where your money goes. Make sure to look at your investments options, and consult with your financial advisor about the best ones for you.