401k Basics: The What and The Why?
By Todd I. Youngdahl, CFP®
If you are a full-time employer and are offered enrollment into a 401k as one of your job benefits, you should definitely take advantage of this opportunity, especially if you plan to retire one day.
Here are the basics about 401k plans as well as a slew of reasons to take advantage of them.
A 401k is a tax-advantaged employer-sponsored retirement account, offered to you (the employee) as a job benefit. This is different than an Individual Retirement Account (IRA) as you would need to go through a financial institution to set up the account and abide by the federal IRA limits. For a 401k account, your employer has everything set up. All you need to do is fill out the forms provided by your employer and instruct how much you would like to contribute from your paycheck every month. As of 2020, the maximum limit for contributions into your 401k is $19,500, and $6,500 for catch-up contributions.
As mentioned earlier, 401k plans are tax-advantaged. Depending on the type of 401k plan you have, your plan is either exempt from taxation or is tax-deferred.
If you have a traditional 401k, your account is funded with pre-tax dollars. In other words, your money is placed in your 401k now, and when you are ready to withdraw money after you retire, then you pay taxes. This is known as a tax-deferred account. A traditional 401k provides you with tax benefits now.
If you have a Roth 401k, your account is funded with after-tax dollars. Contributions from your paycheck are taxed immediately and then placed into your 401k. When you retire, you are free to withdraw money tax-free as the taxes were paid ahead of time. Roth 401k accounts provide tax benefits in the future at withdrawal.
Regardless of what kind of 401k you have, you stand to benefit from either one in the short term as you would have less income earnings to file with your taxes, putting you in a lower tax bracket and paying less in taxes overall.
Company matching is when your employer matches your contributions up to a certain percentage of your paycheck, provided that you are contributing that same amount or more. For example, if your company matching is 100% of 3% of your pay and you are contributing 6% of your paycheck, then your employer will add the equivalent of 3% of your paycheck from their funds. Think of it as free money from your employer. If this benefit is offered to you, definitely take full advantage of the opportunity by enrolling in your 401k program and ensuring your contributions qualify you for company matching.
Unless you are the kind of person who intends to always work, saving for retirement should be a priority—no matter how young or old you are. The sooner you start, the more you will benefit as your compound interest will increase over time. However, the more you hold off on saving for retirement, the harder it will be to reach your target goal and would require more catch-up contributions and possibly settling for a smaller retirement portfolio. Make sure you get your retirement savings set up as soon as possible.
If you have yet to enroll in your employer’s 401k plan or are unsure as to which type of 401k plan is best for you, we would love to meet and discuss your options. To schedule a meeting, please call our office at 703.584.2700 or email email@example.com or use our online calendar to schedule time with me. Our initial consultation is always complimentary!
Washington Wealth Advisors is a fee-only registered investment advisory firm serving busy families, executives, women building wealth, and small business owners. We provide Wealth Advisory Services—financial planning coupled with asset management—guided by a personalized investment strategy based on each client’s unique goals. Our unbiased advice, independent approach, and proactive investment management help to support our clients’ overall financial peace of mind.