By Paul McCoy, CIMA®
While retirement may seem lightyears away, any seasoned financial professional will tell you that planning for your golden years should start as early as possible. While 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) is a retirement savings plan that is oftentimes part of many company’s benefits package. This plan enables you to defer money from your paycheck to be put into a 401(k) investment account. In addition to your personal contribution, many companies will also put money into your 401(k), "matching" a portion of your allocation.
Usually, there will be a pre-set amount that is deferred from your paycheck, but you can alter how much you want to put into your 401(k). You may choose to dial the amount up or down depending on your financial situation and your company’s offerings. For example, if your employer matches exactly what you put in and you are financially stable, you usually will want to contribute as much as you can might to your 401(k).
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), you save on taxes now in two ways. First, since your reported salary is reduced by the amount put into your account, you’ll pay fewer income taxes. Second, the money inside the account grows tax-deferred, so you don’t have to pay tax on the gains each year. You’ll only pay tax on the amount you withdraw during retirement.
With a Roth 401(k), contributions are made with after-tax dollars, and you do not pay on the amount withdrawn during retirement. Unlike the traditional 401(k), you’ll save on taxes in the future rather than in real-time. With this plan, you do not reduce your earned income by the amount contributed to your account. However, your account will grow tax-free, and you’ll withdraw money tax-free during retirement. In addition, the Roth 401(k) doesn't have restrictions due to income limits, therefore, allowing high income earners to contribute to a Roth 401(k).
For the tax year 2020, the contribution limit will be $19,500 per individual. If you have multiple plans, the combined contributions are capped at $19,500. If you. The 401(k) catch-up contribution limit if you're 50 or older in 2020 will be $6,500 up from $6000 in 2019.1
Choosing the Right 401(k) Plan for Your Situation
If your employer offers both a pre-tax 401(k) and a Roth 401(k), you’ll have to decide which plan is right for you. You’ll pay taxes on a pre-tax 401(k) when withdrawing, but you’ll pay taxes on Roth 401(k) contributions now, and this difference will play a role in choosing the best plan for your needs.
Usually, it makes sense to make Roth contributions in the early stages of your career when most people have a lower salary because your tax rate will not be as high. In this way, the impact on your dollars will not be as severe as it would be with a higher tax rate due to a higher salary. On the other hand, you may prefer to make pre-tax contributions during the later stages of your career when your salary is higher because your tax rate will also be greater.
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 stage of their career but their employer only offers a pre-tax 401(k). In this scenario, opening a Roth IRA enables 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, like different mutual funds. You’ll want to thoroughly explore these options and consider which one is fitting for your circumstances.
Is Your Employer Contributing to Your 401(k)?
In many scenarios, your employer will also contribute to your 401(k). These contributions are pre-tax, so you’ll only pay taxes on the money when it’s withdrawn in retirement. There are several types of employer contributions:
With a matching employer contribution, your employer contributes the same amount as you. In some circumstances, there is a minimum amount at which your employer will contribute. If this is the case, some may decide to contribute at least the minimum. Make sure you understand your companies match provision to maximize your company match.
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), employers will 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 its employer’s contributions after a certain number of years in the company, otherwise known as “vesting.” When you’re vested after a certain number of years, you now own the contributions made by your employer.
If you want to make the most of your employer’s plan, you’ll want to find out when you are vested. You may decide to part ways with your job only after you are vested, allowing 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 decide how to make the best of the plan for 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.