What is a 401(k)?
A 401(k) is a retirement account that is sponsored by the employer. This account allows employees to prepare for their retirement by dedicating a percentage of their pre-taxed income to a separate account. In other words, every pay period a percentage of the income you earn from your employer will be placed into the retirement fund. In addition, the majority of companies will match your contribution up to a certain percent. Within the account, you can invest the saved money into vehicles such as stocks, bonds, index funds, mutual funds, etc. which can exponentially grow the amount over time. However, the money that has been built up in the account will be withheld until retirement which is age 59 1/2.
What are the benefits of using a 401(k)?
- Using a 401(k) will help you prepare for retirement.
- A 401(k) will decrease your taxable income, leading to tax advantages.
- If your employer matches, you will receive essentially free money every pay period.
- Once set up it takes little to no effort to maintain.
- Money can grow undisturbed at a compounding rate if invested well.
- The early you start the greater the amount collected at retirement.
What are the drawbacks of using a 401(k)?
- You must wait until age 59 1/2 to obtain money penalty-free.
- Early withdraws will receive a 10% penalty.
- The withdrawal at 59 1/2 is taxed.
- The income from your employer will seem lower.
- Your money can be lost if not invested well.
How much can I contribute?
The annual contribution limit for an employee into a 401(k) in the year 2021 is $19,500. Therefore, it is recommended that you contribute 10-20% of your income when possible. Moreover, the combined employer and employee contribution limit in 2021 is $57,000. Although, employers that match typically only match %50 of what you contribute up to %6. In other words, if you contribute %6 or more of your paycheck into the retirement account, your employer will only contribute the equivalent of 3% of your paycheck.
A 401(k) retirement account can be an intelligent financial move to prepare for the future and gain tax advantages, especially if your employer matches. The earlier you open this account and consistently contribute the more years it has to grow. On the other hand, doing so will essentially lock a percentage of your money away for a long time depending on your age. Evaluate the pros and cons and how they will affect your current situation before investing in a 401(k).