A 401(k) is an employer-sponsored retirement plan. It’s a way to start saving for retirement, even during the years when that’s the last thing you want to worry about. Trust me, give it the 45 minutes worth of thought that it takes to set up a 401(k) plan. You don’t have to think about it again for months, and by then you'll take a look at your balance and feel like you achieved something. Here’s how a 401(k) works and why you want to be part of one.
You can contribute money to a 401(k) account on a pre-tax basis. That means it’s taken out of your paycheck before taxes are withdrawn. Think of that: you get the savings lobbed off first, so you are taxed on a smaller amount of income. You don’t feel it as much in your salary—and the more you save, the lower the taxes you pay. Don’t believe me? Take a look at a 401(k) calculator to get a sense of what would happen to your paycheck if you were contributing 3%, 6% even 10% of your pre-tax salary.
Get Started Investing
There will be a range of investment choices within your 401(k) plan. Mostly stock mutual funds, bond mutual funds, money market funds and/or stable value funds. You can pick one fund or many, based on how much you want to pay attention to your portfolio. If you’re not interested in the ins and outs and can afford a little risk, you can find an inexpensive stock index fund, like an S&P 500 or Russell 3000 fund, that will give you the performance of the larger market. If you are more conservative, you are also likely to find a target-date retirement or lifecycle fund. These funds pick a part-stock, part-bond strategy based on your likely retirement age, starting more aggressively and getting more conservative over time. Or you may love the fun of researching funds and allocating assets, and decide to select a handful of funds to create a fully diversified portfolio based on your unique tolerance for risk. For whatever type of investor you are, there is probably an option to suit you.
Money invested in a 401(k) grows tax-deferred. That means if your investment earns money you don’t owe taxes on it until you retire after age 59 ½. All else being equal, tax-deferred investments compound and grow more quickly than those that take an annual tax haircut. Plus, you can move money around easily in a 401(k) without immediate tax consequences. Tax-deferred compounding is the reason you will do better as an investor the earlier you start. So start right away with a 401(k).
If you are one of the lucky folk whose employers match contributions, you must take advantage of it. Employers will typically offer a 50% to 100% match for up to 6% of an employee contribution. There may also be vesting involved. A vesting schedule is the rate at which you receive your full match. These days, employers will attempt to incentivize loyalty by giving you your full match after a period of five years or more.
Those are all of the reasons you should invest in a 401(k). If you're still not convinced, let's consider the reasons you may not want to:
Reason 1: I don't have enough money as it is, I can't afford my 401(k) plan.
Answer: You may not even feel the impact of your contribution after taxes. Try to contribute 3% to 6% and see if you have room to adjust your budget slightly. If not, there's no penalty if you stop contributing.
Reason 2: I'm afraid of the stock market. What if I lose money?
Answer: You don't have to invest in stocks. You can put your money into bond funds or super-safe cash equivalent funds. There are many investment options in a 401(k). But don't fear stocks too much. With regular contributions to a 401(k), you will be buying investments in all kinds of markets. You will gain and lose money without even noticing it. But in a couple of years, you'll be surprised by how much you've amassed in savings. That amount may go up and down in market swings. But the alternative is having nothing saved. Plus, when investments go down, you end up buying more shares of your mutual funds at a discount.
Reason 3: I live for today. Who cares about retirement?
Answer: I don't know if anyone is asking this question, but if you are, you're being a short-term thinker. Many of us will live long lives with financial hardships and hopefully some triumphs. Building a nest egg now will help you face life's uncertainties with a little security. The earlier you start, the better. Don't think of it as a retirement fund, call it an emergency fund that you hope you won't have to access before retirement. If you need the money, you can withdraw funds early from a 401(k), but you will likely pay a 10% penalty fee plus any federal, state and local taxes.
If you don't have a 401(k) or are self-employed, check out my list of self-employed retirement plans.
I have a friend in her 40s who just signed up for her 401(k) within the past 10 years. Whenever she talks about her finances, she mentions the 401(k), calling it "the best thing I ever did." I agree with her. Why haven't you done it yet?
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