As we see traditional pension plans slowly going away, there has been a rise in employer sponsored 401(k) plans. Many individuals are automatically enrolled when they are hired on or at the time of enrollment. However the big question is what is a 401(k) an why is it so important? If you are here because you don't know where to start or are looking to learn a little more you are in the right place.
What is a 401(k)
According to the IRS.gov a 401(k) is a feature of a qualified profit-sharing plan that allows employees to contribute a portion of their wages to individual accounts. What does this mean? This means that the 401(k) plan is a plan that is set up by the employer that allows employees to make contributions to a retirement account.
Who Sets Up A 401(k)
A company may choose to set up a 401(k) plan in order to attract employees to their company. The company may go through an investment firm to help set up the plan as well as administer the plan.
Who Can Contribute?
401(k) plans allow for employees to contribute up to the maximum allowed amount. For 2022 that amount is $20,500. Many employers have a matching principal. An employer may contribute funds to an employees account under certain requirements set by the plan.
How Does Matching Work?
A common question asked is how does matching work? An employer match is usually expressed as a percentage. For example 6%. If the employee wants to get the employer match in their 401(k) the employee needs to contribute at minimum 6%. Once the employee contributes at least the minimum amount the employer will match your contribution. That's money that the employer gives you just for saving! All plans are different so depending on your plan the employer may contribute 100% up to 6% or 50% up to 6% or some other amount described in the plan.
This is where it gets fun. To make this simple we will use an example. Lets say you have an annual salary of $100,000. You contribute 6% of your salary to your 401(k) plan. Your employer will match 50% up to 6%. Here is how that looks.
Your contribution= $6,000 ($1000,000 x 6%)
Employer match= $3,000 ($6,000 x 50%)
Does The Employer Match Go Toward My Maximum Contribution?
You may be wondering if the employer match counts towards the $20,500 limit. It doesn't. The employee may contribute the full amount and the employer may contribute money on top of the personal limit.
How Much Do I Contribute?
This is a great time to consult your financial adviser. They can help plan out how much you need to set aside for retirement. However if you are just looking for a ball park estimate 10% is always a good starting point.
One strategy that can be beneficial to you is to consistently increase the amount you put in each year. Some plans allow you to increase your contribution each year automatically, that way you can keep increasing your savings. Another strategy is to increase the percentage when you get a raise. It never hurts to set aside more for your future.
What Happens To My Contributions?
When you first set up your 401(k) you are given a list of funds that you can choose to invest in. You are allowed to re-balance these funds at any time along the way. This is another great time to consult your financial adviser because it can be trick deciding which funds to choose that meet your financial goals. As you get paid the money that you contribute to your 401(k) gets invested into each of the selected funds that you chose.
I Changed Jobs What Happens To My 401(k)?
If you happen to change jobs there are 2 options you have. The first option is to roll your 401(k) over into the new 401(k) plan if that company offers one. The second option is to roll your 401(k) into an IRA. The benefit to rolling into an IRA is control. Given that a 401(k) plan has a limited amount of funds to choose from, you can only make the best investment with those select funds. When you roll these funds into an IRA you have more control over the investments to choose from, and who doesn't want more control of their money?
Can I Borrow From My 401(k)?
The answer is yes, although you may want to save this as your last option. You are allowed certain qualified withdraws from your 401(k) but it is not recommended.
When Can I Withdraw From My 401(k)?
You may withdraw from your 401k penalty free at the age of 59 and 1/2. this means you will not have to pay the 10% early withdraw. The 10% early withdraw is for individuals who take withdraws earlier than 59 and 1/2. These early withdraws are not recommended because on top of the 10% you are also paying taxes on the contributions
I Retired Now What?
If you are retired you have two options. You can begin to take distributions from your 401(k). Or you have the option to roll the funds into an IRA. The later is suggested because you will have more control over your investment.
Your Financial Adviser Is Your Best Friend
It is important to consult with your financial adviser before enrolling in your company's 401(k) plan. Your adviser can help walk you through how to select funds that align with your financial goals. Through this process your adviser can help select the highest quality funds with the lowest expenses to help maximize your 401(k) return. If you change jobs and need help moving money from a 401(k) to an IRA. Consulting with an adviser will help make this transition seamless.
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