You should never invest in anything you don’t understand. And you definitely need to be investing if you plan to retire. Thankfully you don’t need a finance degree to understand the basics of a 401(k) and begin building a strong retirement account.
Let’s dig in so you can start building up your 401(k) today.
A 401(k) is an Employer-Sponsored Retirement Account
The first thing to know about your 401(k) is that it is an employer-sponsored account. This means that your employer offers you, their employee, an account. Don’t worry, the account and everything you personally contribute will always belong entirely to you. Your company cannot withdraw or allocate any of the funds you deposited into your account. A 401(k) is simply a benefit your company offers you as their employee – like insurance, discounts, free training, or education credits.
As an added benefit, many employers offer to match your 401(k) contributions in some way. We love matching because it’s free money that will grow for you until you retire. Who doesn’t like free, interest-accruing money?!
Some employers offer to match up to a certain percentage of your annual salary. Others offer to match up to a certain dollar amount. Each company is able to determine their matching guidelines, as long as they don’t exceed the IRS established maximum contributions in any given year.
Remember though, not all employers offer 401(k) matching. Be sure to check with your HR department or manager to determine what kind of matching opportunities are available to you.
While your contributions to your 401(k) belong entirely and fully to you, your company’s contributions to your account may not. Companies often have what is called a “vesting schedule.” A vesting schedule refers to the amount of time an employee needs to have with the company before a company’s investments into the employee’s 401(k) account belongs entirely to the employee.
This may happen gradually, or entirely on a specific date. Again, each company is able to set these guidelines for themselves. This creates an incentive for an employee to stay with an employer, to make sure they capitalize fully on their employer contributions to their 401(k).
You can learn more about vesting schedules here.
There are limits to how much both you and your employer can contribute to a 401(k) in any given year. In 2020 the employee contribution cap is $19,500. If you’re over 50 you may contribute an additional $6,500 in “catch-up contributions.”
The IRS sets the limit for employer contributions every year as well. In 2020, your employer may contribute an additional $57,000 to your 401(k). When your employer contributions reach $57,000, no additional funds may be added to your 401(k) in that year.
The much higher cap on employer contributions is one of the main reasons you should take advantage of your employer match. You can potentially almost triple your annual contribution for free every year if your employer maxes out their contributions to your account.
401(k) Tax Benefits
A 401(k) is a tax-deferred account, meaning you receive immediate tax benefits on all your 401(k) contributions. Every dollar you contribute to your 401(k) is tax-deductible. That means that every dollar you contribute is one less dollar you must pay taxes on in that year.
For example, suppose you made $45,000 this year and contributed $10,000 to your 401(k). You would be responsible to pay taxes on only $35,000. That being said, you will eventually have to pay taxes on your 401(k) investments. Once you retire and begin pulling from the account, you will be taxed on your withdrawn-earnings.
Why 401(k) Investments are Important
While the tax-deductions are nice, they’re not the real reason we love 401(k) investments. The real reason you want to be investing in your 401(k) as much as possible is a little thing called compound interest.
When you invest in your 401(k) you begin to make returns on your investments. Those returns are invested back into the market and then they begin to make interest as well. This process continues to repeat itself as long as your 401(k) has a balance. This means, assuming your investments make a return, the more you invest and the earlier you invest, the more you stand to make.
You can learn more about compound interest and how it works by checking out this blog here.
Your 401(k) Puts You In Charge of Your Retirement Future
One of the things I’m most passionate about is putting you in control of your financial situation – present and future. A 401(k) puts you in charge of your financial future. It allows you to build wealth to prepare for your eventual retirement. Social safety nets may or may not be there when it comes time for you to retire. Banking on something that you have no control over puts your financial future at risk.
Investing in your 401(k) is one of the easiest ways to take control of your financial future and to build yourself a strong retirement. It’s not complicated and the benefits available to you, especially if you’re able to maximize your investments from an early age, are incredible. Your 401(k) puts compound interest to work for you!
Hopefully, you’re feeling informed and inspired and take steps today to begin making the most of your employer offered 401(k) account.
If so, let me know on social media!
I’d love to hear from you and to learn how this content helped you.