There are so many different investment schemes in the financial world that it can sometimes be difficult to remember where your money is actually going. In this Money Mentor, we take a look at what a 401k plan actually is.
What Is A 401k?
In its simplest form, a 401k is a type of savings account for your retirement.
Most employers in the United States offer some form of 401k plan, though they may be called something else depending on what kind of work you do.
Ask your employer or HR department about their own specific 401k plan for further information.
How Does A 401k Work?
With a 401k, money is paid straight into this savings account from your paycheck. The company that runs the plan will then invest the money for you so you can have additional income to live on when you retire.
Most plans will have a number of options for you to choose how you want that money invested – depending on your tolerance for risk. The younger you are, the most risk you should be willing to take as you have many years to recoup any losses.
As you get older, you’ll want to protect all that money, and can switch to a low risk option.
To make things easier, you can choose to have your 401k invested in a Target Retirement Fund. These are funds run by Vanguard, Fidelity, and other investment management companies, that change the risk profile of your investments as you get closer to retirement.
Simply choose the fund that ends closest to the year you plan to retire, and leave it to the fund managers to manage the risk accordingly.
The best thing about 401ks is that many employers will match your contributions to a certain amount.
That means that your employer will put in extra money into your retirement plan relevant to what you contribute yourself. If your employer provides this and you don’t take full advantage, you are literally passing up free money!
A 401k also has significant tax advantages that a normal savings account doesn’t.
When you save money with your 401k, you are deferring your income. Therefore you don’t have to pay tax on that income until you choose to withdraw it when you retire. Keep in mind that when you retire, you will likely be on a lower income and so will end up paying less tax on that money.
A Roth 401k
Some firms give you the option of choosing what’s called a Roth 401k. This is the same as a 401k, but you pay the taxes upfront on the money you save so you won’t have to pay anything when you retire.
If you are young and in a low paying job, a Roth 401k may be the best option for you becuse you probably won’t be paying much tax at the moment anyway.
There’s a limit to how much you can contribute to a 401k. Should you wish to save more for your retirement, you can set up an Individual Retirement Account (IRA). These operate in a similar fashion to 401ks.
Keep in mind that you’ll face a hefty penalty if you try to remove funds from your 401k before you retire, so don’t treat this like a bank account.
You should aspire to max out your 401k contributions, but be careful not to put yourself in financial hardship every month and end up incurring debt as a result.
Also remember that investing is a great way to save for the future too! In addition to contributing towards a 401k plan, you can also buy stocks in some of your favorite companies and watch your long-term wealth grow.