Millions of Americans do not put away enough money to retire comfortably. Many are unsure of how much they will need later on in life, and the process of saving up for retirement can seem both complex and time-consuming. But proactively selecting the right savings approach can translate into less stress and more substantial financial resources available for your golden years.
401(k) plans are one method of retirement preparation that financial advisers urge Americans not to forgo. If you are lucky enough to have an employer who offers one of these programs, opt in as soon as you can and let the monetary magic of compound interest begin working in your favor.
Companies can have different eligibility requirements and/or scheduling processes in place that determine when you can enroll and begin saving to a 401(k) plan. Once you have enrolled, you decide the percentage of your salary that you would like to contribute. Each pay period, depending on the percentage you decide to save, a designated amount will be automatically deducted from your paycheck and placed into an investment account.
Be aware that there is a limit to how much you can contribute. Currently, the monetary cap for personal deposits into a 401(k) plan is $17,500 per year. However, individuals age 50 and older are permitted to make $5,500 in additional "catch-up" contributions. These limitations are evaluated annually and adjusted to reflect inflation.
A 401(k) is not a hands-off savings tool. You will need to investigate the investment opportunities that your employer offers through their 401(k) program and select the best option(s) for your situation. Depending on what your company's program offers, these investments can include mutual funds, stocks, bonds, stable value funds, etc.
Different companies, different needs, different plans
In addition to the traditional type of 401(k) plan, there are a few other categories of defined contribution payment plans that may be available to you, depending on what kind of business you work for and what your needs are. There are a few subtle differences between these programs, but fundamentally, they all function the same way:
- Roth 401(k) plans: One final employer-provided savings plan that you may have access to is a Roth 401(k), which work the same way as traditional 401(k) plans, but in reverse. With a Roth 401(k), your contributions are taxed as they are put into your account, meaning your money is able to grow and be withdrawn tax-free, as long as you wait until after age 59-and-a-half to begin taking out money. Any money withdrawn prior to that milestone may be subjected to a ten percent penalty fee. Some employers may make their workers select either a traditional or Roth 401(k) plan, while others allow employees to participate in both. It's important to note that if you do choose to save money in multiple plans, the contribution limits set by the IRS for you and your employer remain the same in total, just split between the plans.
- 403(b) plans: Traditional 401(k)s are offered by for-profit companies, while 403(b) plans are offered by tax-exempt, non-profit organizations such as hospitals and schools.
- Thrift Savings plans: Some government workers even have their own versions—Thrift Savings Plans—that are only available to federal employees, including members of the armed services.
- 457(b) plans: State and local government employees can prepare for retirement using 457(b) plans (some non-profits may offer these, as well).
Tax breaks and other big benefits
Aside from the obvious advantages of proactively saving for your retirement, 401(k) plans' attractive tax deferrals mean that you immediately benefit from participating. Since your contributions are deducted from your paycheck before taxation, your resulting taxable income is lower. Thus, you'll pay fewer taxes overall and only see a slight difference in take-home pay.
All of this contributed money will be taxed eventually, though, so it literally pays to put-off withdrawing money from your 401(k) account. If you successfully wait until after the target age of 59-and-a-half to begin withdrawing from your plan, you will only be responsible for taxes at that future rate (which, for most people, is lower than when they put the money into their 401(k)).
Another powerful incentive that is available through some 401(k) programs is employer matching. This means that your employer will agree to match a certain percentage of your contributions, totaling up to no more than a certain percentage of your salary (commonly three or six percent). No matter how small these matching contributions may be, if you can afford to put aside the minimum required to earn them, do it! Otherwise, you are leaving free money from your employer on the table.
Know that you understand the basics of these employer-sponsored retirement savings plans, take a look at these Tips for Choosing a 401(k) Plan.