Greetings friends! Today’s post is brought to you by the following Tweet:
This was sent to me by a couple friends partly as a joke but mostly because they totally feel this Tweet and actually wanna know what the f*** a 401(k) is.
We’ve all heard of 401(k)’s before and many of you might even be saving in one but still have no idea what you’re doing or why you’re doing it. I understand because I’ve been there!
I started saving in a 401(k) when I was just 18 years old and had absolutely no idea what I was doing. I worked at a bank and got pretty sweet benefits for only working part time. One of those benefits was a 401(k) with a 5% match.
All I knew was that all the older people that I worked with said “You better start that 401(k), kid! It’s free money. You’ll never find free money anywhere else in life.” Ummm OK Carol, chill.
Carol was right though and I’m glad I listened, but I still didn’t know what I was doing or why Carol was right.
So, what is a 401(k)?
A 401(k) is a retirement savings plan sponsored by an employer. It allows employees to save for retirement in a tax advantaged manner. While there are technically multiple types of 401(k) contributions including Roth or after-tax, the most common is where you can invest a portion of your paycheck before any taxes are deducted. Taxes aren’t paid on those funds until the money is withdrawn from the account.
This means that whatever amount you decide to save will be taken out of your income before taxes are withheld. The amount of your paycheck that actually gets taxed is therefore smaller, so you pay less taxes right now.
When Carol told me this, I thought “WOW NO TAXES, YASSSSSSSSSS”. For years I thought all that money was never taxed, which I later found out was wrong. You don’t pay taxes now, but you can’t escape the tax forever. When it comes time to make a withdrawal (hopefully in retirement), you will be taxed based on how much is removed from the account and what tax bracket you are in at that point.
Why wait till retirement?
401(k)’s are intended to be accounts used to save for retirement and there are rules to make sure that this is how they’re used for the most part. Currently, in order to withdraw money from a retirement account, you have to wait until you’re at least 59 ½ years old. If you withdraw before that, you’ll subject yourself to some hefty penalties. On top of the penalties that you’ll pay for the early withdrawal, you’ll also have to pay taxes.
What about the “free money”?
So Carol and all the older people I worked with kept telling me about this free money. What they were referring to was the match from my employer. Most companies (but not all) will offer some type of match for your retirement account. They’ll usually say something like “we’ll match up to __%.”
For example, when I was working at the bank, the match that they offered was 5%. This means that if I decided to contribute 5% of my paycheck to my 401(k), they would also contribute that exact same amount to my account. If that 5% ended up being $100 per check, the bank would also deposit $100.
That was the free money everyone talked about. It’s definitely something you should be taking advantage of if your employer offers it.
How much should you be saving in your 401(k)?
The answer to this question really depends on you, your goals, and how much you can afford to put aside for retirement. Ideally, you should be saving as much as you can but at the very least try to aim for whatever match your company does if they do. If it’s a 5% match, try to at least save 5%.
Why, you ask? Because if your company offers to match 5% and you only do 3%, that means you’re missing out on that 2%. In other words, you’re leaving money on the table!
If you can afford to save more, you should. Remember that this is to help you save for retirement which seems like something so far into the future but it’s so important.
How much CAN you save in a 401(k)?
There are limits on what you can contribute to retirement accounts. In 2019, you can contribute up to $19,000 per year to a 401(k). You can find all contribution limits directly from the IRS here.
What does your money get invested in?
So now that we know what a 401(k) is and some of the rules, you should know that typically your money is invested in the stock/bond market. Usually, there will be multiple different options within the 401(k) that offer exposure to stocks, bonds, or a combination of both. What funds you ultimately decide on will be dependent on your risk tolerance, as well as your age and time horizon before retirement.
Your company should have contact information for financial professionals that can help guide your decision. You should always consult a professional when making investment decisions and nothing in this post should be taken as actionable investment advice.
A 401(k) is an employer sponsored retirement account that allows you to save for retirement on a pre-tax basis and usually your employer will match up to a certain amount. If you have one available to you, you should definitely take advantage of it.
Saving for retirement is important and the sooner you start the better.
Nothing on this blog should be considered personal actionable advice, research, or an invitation to buy or sell any securities. Consider all risks before investing, including the loss of your hard earned money. Vee is an Investment Advisor for Warren Street Wealth Advisors, this blog reflects her personal views, and not that of Warren Street.