“401(k)” is one of those terms that frequently gets tossed around in regular finance or work conversations, but how well do you understand it?
A 401(k) is an employer-sponsored savings account with perks. Money is automatically deducted from your paycheck, goes into an account, and is invested on your behalf. Once there, you have the responsibility to invest it into different investments, most often mutual funds, which may hold stocks, bonds, or REITS (Real Estate Investment Trusts).
Because money is withheld from your paycheck, and deposited regularly into your account, you are using an investment method called dollar cost averaging. This occurs when every deposit purchases shares at different prices, because of the market fluctuations. Some deposits are made when the market is low, and others are made when the market is higher, giving an average cost for all shares owned.
Early on in your career it may be a good idea to invest in some higher risk/return securities like stocks. This gives you time to ride the fluctuations of the stock market. Later on in your career you might want to shift those investments to more stable choices like bonds.
The name 401(k) comes from a section of the Internal Revenue Code that authorizes profit-sharing plans. This term is now used to describe these employer-sponsored retirement plans that specifically use this code.
There are two types of 401(k)s. There is the traditional 401(k) that takes money from your paycheck PRE TAX. This means that your money that you invest in your account is not taxed at the time it is earned, and your investments grow tax deferred.
The second type is a Roth 401(k). This takes money from your paycheck after it has been taxed.
These differences really come into play when you begin taking money out of your 401(k) during retirement. If you have gone with the traditional, the contributions and earnings will be taxed when they are withdrawn. With a Roth 401(k) your withdrawals will not be taxed, because you already paid taxes on that money before it was put into the account.
Some employers offer to match your contributions to a certain percentage. If this is an option take it. It’s a good idea to, at the very least, take advantage of matching benefits. In these situations the employer is taking money from corporate profits and assisting you in planning for your retirement. (This is why 401(k) plans are often referred to as profit sharing plans.)
There are two key ages that come into play with a 401(k) - 59 ½ and 72. If you take money out of your 401(k) before the age of 59 ½ you will get hit with a 10% early withdrawal penalty tax.
At 72 you must begin taking Required Minimum Distributions (RMDs). The RMD age was increased from age 701/2 to 72 last year as part of the COVID funding laws.
Additionally, you can continue to contribute to your 401(k) for as long as you are working. If you are still working at the age of 72, as a participant you do not have to take RMDs from that 401(k).
If your employer offers a 401(k) it may be a good idea to jump on board. When you reach retirement, all that will be there is what you have sent on ahead. Save and invest lots! At retirement, you are replacing your physical work with your dollars working for you, and you want as many dollars working for you as possible. That is how you Secure Tomorrow!
“Good investing is simple: buy a good asset at a good price and hold it for a good long time.”
-Adrian Day
The Maxims of Wall Street by Mark Skousen