A 401K is a type of retirement account that many companies offer their employees. If you work for a large corporation, chances are that you will be offered a 401K plan. It's a salary deferral retirement account that allows you to contribute part of your income to save up for your retirement.
If you’re not sure if your company offers a 401K, ask your HR representative. As of 2011, 60% of Americans nearing retirement have 401K type plans. If you work for a non-profit organization, your plan will be called a 403B, but for the rest of this article I will refer to both types of retirement plans as 401K.
Your 401K account uses pretax money for investment. This offers a huge tax advantage for you. Do you know your tax bracket? Let’s say it’s 25%. Other investments require you to use after tax money, but with your 401K, you are using pretax money. It’s like getting a 25% bonus to invest with. None of your contributions are taxed until you withdraw it when you retire. Any money you invest in your 401K is also free from income tax.
Let’s say you make an income of $100,000 a year and you invest $10,000 each year into your 401K. Tax on your income is now based on $90,000 and not $100,000.
Many employers offer a 401K match on a part of your contribution. This is wonderful and it’s like getting a free raise. This match is usually between 3% to 6% of your retirement contribution.
How much should you contribute to your 401K?
It’s suggested to put 10% of your income automatically into your 401K. If you don’t feel like you can invest 10% of your income into your 401K right now, at least invest enough to reach the company match. For example, if the company match is 3% - start with that. Then every 3 to 6 months, consider increasing your contribution by 1%. You won’t notice the difference since a portion of your income is automatically sent to your 401K and you will never see it on your paycheck. You will learn to live without that small percentage on your paycheck and your money will be automatically working for you.
Let’s say you make a salary of $50,000 a year and your employer matches up to 5% of your contribution. You contribute 5% of your income, which is $2,500 every year. Your company will now match that investment by another $2,500 so you are now making an actual investment of $5,000 per year.
This is free money and you would be a fool not to take it. If your employer offered you a raise, would you turn it down? No. Always contribute enough to reach your 401K match - then build from there.
Now if your employer is not generous enough to offer a 401K match, you should still open up your 401K. But first pay off all of your debts and max out your IRA contribution prior to investing in your 401K.
Setting up a 401K is simple. Many companies now are automatically enrolling their employees in a 401K plan. This is because studies find that when employees are given too many 401K choices, they end up getting overwhelmed and do nothing. If you are not automatically enrolled in the company 401K plan, call your HR representative and find out how to sign up.
The 401K sign up process is very simple and requires very little effort. All you do is choose a percentage of your paycheck that you want to invest automatically, and then choose an investment. These investments usually include: mutual funds, target date funds, stocks, bonds, or money market accounts. If you don’t know what investment to choose, your HR department should be able to connect you to the right people to advise you. My only advice: don’t put your money into a money market account - the interest you earn on this type of fund won't get you very far.
What happens to my 401K if I leave my job?
Don’t worry about leaving your job because all the 401K money is yours to transfer to another 401K or roll over into an IRA. You should NEVER cash out the money. If you do, you will pay income tax on the money and also a 10% early withdrawal penalty.
Let’s say you worked for a corporation for a few years and saved up $10,000 in your 401K account. If you’re in the 25% tax bracket and you cash out this money you will only be left with $6,500.
Let your money work for you in your retirement account instead. Don’t be an idiot.
Every dollar you invest right now will be worth much more in your future. If you’re working right now, you need to already start thinking about your retirement.
What are my 401K investments?
10% Vanguard Health Care Index (VHCIX)
71% Mass Mutual Large Cap S&P 500 Index Fund (MMIZX)
6% Vanguard Mid Cap Index (VIMAX)13% Vanguard Small Cap Growth Index (VSGAX)
10% Vanguard Health Care Index (VHCIX)
Currently I’m maxing out my 401K with annual contributions of $18,000. When I first got hired and started contributing into my 401K, I started off at 7%. I slowly increased it by a few percentage points every few months. Next thing I knew it, I was set to max out my 401K. The maximum investment one can contribute into their 401K is $18,000 per year. I am also maxing out my IRA, which is $5500 a year.
This week, find out if your company offers a 401K. If it does, make sure you're enrolled and contributing enough to meet the company match. Then slowly work to increase your contributions until you max out your 401K. If your company doesn't offer a 401K, consider getting together with your coworkers and asking for one in the suggestion box.