What Are The Details You Should Know About A 401(k)?
The 401(k) is one of those things that is frequently discussed in the workplace. Despite all of the conversation time it takes up, few fully understand what it is and how they can benefit from it. They want to have 401 k plans explained in a way that makes sense to them. That is what this piece intends to do.
Preparing For The Future
In the most basic sense, a 401(k) is an investment vehicle designed to help people better prepare for their future. It is supposed to allow them to live the kind of life that they have always dreamed of. Most people will use their 401(k) to help get through retirement or perhaps for some other big life purpose. In decades past, people could rely on their employer to provide them with a pension. This was money to help them out when they reached retirement age. Most companies no longer offer such plans.
Shifting The Responsibility To Employees
There was a change at some point for employers. They decided that they no longer wanted to take on the entire burden of caring for their employees all the way up through their retirement. They wanted those employees to have to work on it for themselves. The way to do this was to shift to a 401(k) model.
What Is The 401(K)?
A 401 K explained simply is a part of the IRS tax code written a very long time ago. When it was put into the code, no one expected that it would become what it is today. It was just a footnote in a document that most people do not even bother to look at. However, that has all changed now. These days, a lot of people know what a 401(k) is.
It is no longer just a tax footnote. Rather, the 401(k) is an employer sponsored way to invest money into the stock market. With time, funds added to the 401(k) are very likely to grow. The more money placed in the 401(k), and the greater the return, the more one can expect to have to retire on.
How Much Do I Contribute To A 401(K)?
Each individual employee must decide for him or herself how much to contribute to a 401(k) plan if anything at all. Most financial experts would recommend that a person put in at least the percentage of income that the employer will match on their 401(k) contribution.
Employers often elect to match up to a certain percentage of what an employee puts into the program as a way of giving them a boost and helping them achieve their investment goals. Many employers set that matching limit at around six percent. This is the mark that employees should reach for at a minimum. If they can put away six percent, then they can take advantage of that full match that the employer is offering. It is basically free money sitting on the table!
How Are These Things Taxed?
It is a very fair question to wonder about the tax implications of such investment vehicles. People often wonder what part of the pie Uncle Sam is going to take from them as a result of their contributions to their 401(k). To answer that question, one must first know if the contribution in question is towards a traditional 401(k) or a Roth 401(K).
Are 401 K contributions taxable? Yes, but the way in which they are taxed is very different between the two types of funds. A Roth IRA is taxed as the money is invested. In other words, the funds that go into the 401(k) are post tax dollars. To allow this to make more sense, consider the following example:
Let’s imagine that John is an employee who makes twenty dollars per hour and works for exactly forty hours per week. He earns a gross income of eight-hundred dollars per week as a result. Let’s now imagine that he is taxed at a rate of exactly twenty percent. This means that he nets six-hundred forty dollars after his taxes are taken out.
This same character decides that he wants to invest ten percent of his earnings into a 401(k). If he has a Roth 401(k), he will have sixty-four dollars come out of his paycheck for his contribution. That is ten percent of his post tax earnings. However, if he has a traditional 401(k), he will have eighty dollars go into his 401(k) as this is ten percent of his gross earnings.
Given this scenario, one might wonder why someone would opt for a Roth 401(k) at all. That is until they hear about the tax situation for a traditional 401(k).
Taxes On A Traditional
Okay, so you understand the scenario describing employee John above. You are now scratching your head and wondering why anyone would ever want a Roth 401(k). It seems that they would only be contributing less money to their investments by doing this. This is true on a week-to-week basis, but the difference comes into play when one starts to make withdrawals from the account.
Since 401(k) accounts are designed to be used for retirement purposes, the idea is that one only withdraws from them when they are of retirement age. That means that their money will have had all of that time to sit there and grow. When they go to withdraw those funds, they will have a much larger sum than when they were first putting the money in. Well, a traditional 401(k) gets taxed at that point.
Yes, you avoid paying taxes on the funds as they go in, but with a traditional 401(k), you must pay the taxes as they come out of your funds. That is often a much larger sum of money paid to the government as a result. Therefore, most opt for a Roth 401(k) if one is available through their employer.
Selecting The Best Investments
The million dollar question for a lot of people is what are the best 401 K investments? The answer to that is not simple at all. A lot of it has to do with how many options are provided by your employer. They are the ones who get to determine what is on the menu of options for you as it relates to your 401(k) choices.
Employers typically partner with an investment firm of some kind to offer products to their employees. Those employees are then left to select between the various options that are provided to them.
It is advisable to review the options presented to you carefully. A lot of people do not know what they are looking at, and that means they often just throw in the towel and give up. That is the wrong course of action to take. Instead, speak with an investment expert. There may even be someone within the company that you can consult with to see what can be very helpful in terms of knowing their stuff and providing you with answers about what is best to put your money into. They will probably tell you that a balanced portfolio that is diversified is what you want to look out for. That makes a lot of sense because you want something that can weather any storm. Examples of investment types you might look into are as follows:
- Growth Funds
- Small Cap Funds
- International Funds
- Target Date Funds
- Bond Funds
- Gold Funds
- Emerging Market Funds
Since so much of the burden of investing now lays squarely on your shoulders, do not allow the opportunity to slip by. You need to be proactive about this and start investing now. The longer you wait, the harder it is to reach the goals you have.