Your new job comes with plenty of benefits, including a 401k retirement plan that you’ve never had before. Perhaps you haven’t decided to enroll yet, or maybe your employer has automatically enrolled you. Some employers require employees to have worked at the company for a certain amount of time before you can take advantage of their 401k plan. Whatever your case is, you probably have a lot of questions.
What is a 401k?
A 401k is a defined contribution retirement plan. You designate a percentage of each paycheck to go towards your savings, and in most cases, your employer will match your contribution up to a certain percentage of your salary. Compare a 401k to your own savings account: instead of depositing money after you receive your taxed paycheck, your 401k contributions are totally tax-free. In fact, the money sitting in your 401k isn’t taxed until you make withdrawals after retirement.
Tell me more about employer contributions.
In most cases, employers will match your 401k contributions up to a certain amount. Some employers match 50% of your yearly contributions up to a certain percentage of your salary; in other, more favorable instances, they will match 100% of your yearly contribution up to a certain percentage of your salary.
For example, your employer will match 50% of your contributions up to 6% of your annual salary. Let’s say you make $35,000 a year, and decide to take advantage of your employer’s contribution match. You’ll put $2,100 into your retirement fund, and your employer will put in $1,050. Essentially, you just gained a free $1,000 just by setting money aside for retirement. Why wouldn’t you want free money for your golden years?
My employer offers a Roth 401k. What’s the difference?
It’s all about the taxes. Contributions to a traditional 401k are not taxed; contributions to a Roth 401k come from your post-taxed salary. You may be wondering why anyone would prefer a Roth plan when they could be making larger contributions with a traditional 401k. The payoff comes once you hit the magic age of 59 ½ .
As stated earlier, withdrawals from a traditional 401k are taxed according to your income bracket. If you had a Roth 401k, your withdrawals would be tax free. Think of it this way: where do you see yourself in 30-odd years? If you imagine you’ll be making six figures (putting yourself in a higher income tax bracket), then you may want to consider the Roth option.
Can I treat my 401k like a regular savings account?
Nope. The allure of untaxed savings is strong, but the penalties for withdrawing early will likely change your mind. Not only will your withdrawal be taxed as income, you’ll be slapped with a 10% penalty. In very dire circumstances, you can try for a penalty-free hardship withdrawal. Qualifying emergencies are slim; for example, you can qualify for a penalty-free withdrawal if you become totally disabled or are swamped with medical bills exceeding 7.5% of your income. You’ll be penalized if you withdraw to pay for a trip to Europe. If you don’t have a savings account already, you need one.
Okay, what can I do with it?
Invest! You may have heard that a 401k can grow over time. That’s true—401ks don’t just sit in a bank account. They’re invested, and often, grow as a result of investments. Stocks are the most popular route; they have the most potential for long-term growth in spite of short term hiccups. People tend to supplement their portfolio with bonds. While bonds don’t offer as large a return as stocks do, they aren’t as risky in the beginning.
How much should I contribute?
As of 2015, the maximum amount people under 50 can contribute is $18,000—a steep number for those of us making our first foray into our careers. The popular suggestion is 10% of your paycheck, but you know your budget better than anyone; don’t dig yourself into a financial hole trying to make contributions you can’t afford. Still, take advantage of your employer’s contribution match if you can.
What happens to my 401k when I change jobs?
You have options, and some are smarter than others. While you may be tempted to cash out and run onto new things, you won’t be moving on with the full amount you’d stashed. As mentioned earlier, you’ll be subject to the 10% withdrawal penalty in addition to an income tax. Clearing out your 401k whenever you leave a job can cost you thousands of dollars, making it, to be frank, a terrible option. Some companies may allow you to consolidate your existing 401k to their plan. That is definitely a smarter move than cashing out; you just need to read over your new employer’s rules, as they may differ from your old plan.
Alternatively, you can roll your 401k over into an IRA account. This is a popular route, and a wise one. A rollover IRA is another tax-free retirement savings plan, often whenever people retire or change jobs. Your funds are still tax-deferred, and can be moved over to your new employer’s 401k if you choose. Unlike a traditional 401k, your rollover IRA contributions have no limit. With an IRA, you have an inch of freedom when it comes to penalty-free withdrawals: you can use funds to pay for education expenses or your first home.
I don’t need to worry about retirement yet; why should I save now?
Short answer: the earlier you save, the more you’ll have.
Long answer: in most cases, you aren’t going to have a sweet pension waiting for you at retirement. It’s up to you to build your retirement fund as soon as possible. While hefty student debt and other expenses may impede you from contributing the recommended 10% of your salary, every little bit counts. Take advantage of your employer’s contribution match. Start investing and contribute as much as you comfortably can. Saving and investing early in your twenties, even if you’re still establishing yourself financially, will put you ahead of stable 30-somethings who haven’t begun contributing to their 401ks.