I’ve been working on an educational blog and thinking about topics which would serve my younger readers. One of the questions I get a lot is how 401(k)s work and how to choose the investments.
Let’s start with some basics about how 401(k)s work:
- What is it? A 401(k) is an investment program set up by an employer. 401(k) refers to the section of the Tax Code which lays out all the rules for this kind of account. A 403(b) plan is a public-sector version of a 401(k), so a lot of what I say here will apply to 403(b) plans as well.
- Contributions: Both the employee and the employer can contribute to a 401(k). Sometimes an employer will match employee contributions entirely, or they will match a certain percentage of employee contributions. If your employer matches contributions, do your best to contribute at least enough to get the match since that is free money for you! Your contributions are also tax-qualified, which means that every dollar you contribute reduces your taxable income by one dollar. The maximum annual contribution allowed in 2019 is $19,000 and if you are 50 or over you can contribute another $6,000.
- Tax: Besides the obvious benefit of the tax reduction, 401(k)s can grow tax-deferred. This means that as the value of your investments increases over time, you don’t pay any income tax along the way. This allows your account to grow faster than a taxable account, since you’re not paying taxes every year. Those gains are taxed when you take the money out, but not before. All withdrawals (the contributions and the gains) are taxed as ordinary income when you take money out. These withdrawals also count as taxable income, so they can bump you up a tax bracket depending on how much you take out.
- Withdrawals: You need to wait until you are 59½ to start taking withdrawals from a 401(k) plan or you will have to pay a 10% penalty and all the usual taxes to the IRS. There are some exceptions, including withdrawals for disability and high health care expenses. But some 401(k) plans will also allow you take loans, which may be an option.
- Fees: There may or may not be a “management” or “account” fee on your 401(k). This is often not transparent and might not appear on your statement, so it’s important to ask. You don’t really have a choice if you want to participate in the plan, but it’s worth knowing. There are also fees on each of the funds you are allowed to select as part of your plan. More on that next time.
- Should I participate? Generally, the answer is an emphatic “yes”! The tax deferral means that, for a lot of people, a 401(k) is the best place to start investing for retirement. Max your 401(k) if you can!
Check out Part II of this post, where I talk about how to invest the money in your 401(k)!
I hope this was helpful for you,
Another required disclosure: This information is for educational purposes. It is not intended as investment, legal, retirement or tax advice. Diversification is a useful technique that can help reduce overall portfolio risk and volatility. Diversification neither ensures a profit nor protects against a loss. Diversification offers returns which are not directly related over time and is intended for the structure of a whole portfolio to reduce the risk inherent in a particular security.