My new job has given me the opportunity to invest in their 401k, but I know little to nothing about the benefits. How does this really profit me, and is it worth the decrease in my monthly income? If I switch to a new job, what are my options with this 401k? I would like to know all of the reasons this investment would help or hinder me.
Dear, Planning for the Future,
First, congratulations on finding a job that truly cares about your future, as not every company offers this luxury. It is essential to prepare for retirement, no matter how far away it may seem. Many of us spend most of our life longing for the day when we no longer have to wake up at 6 am for yet another 8 hours in the office. However, once you retire, you will no longer have the steady income you have been used to for the past 30-plus years. You must start planning early in order to ensure that your finances after retirement do not mirror that of the penniless college student, and what better way to do this than with a 401(k)?
A 401(k) is an employer-provided retirement plan through which you deduct a portion of your paycheck into an investment account and, in many cases, your employer contributes as well. Below are a few ways this plan can better prepare you for the retirement you’ve always dreamed of:
- Many employers match your contribution, putting their own money into your investment account. Typically, they will invest 50 cents for each dollar you put in, usually topping out at 6 percent of your overall income. Essentially, this is free money you really didn’t have to work for! Of course there is a catch: most companies will only match contributions if you input enough money of your own. There is also often a “vesting period,” requiring you to work a certain amount of time, typically 3 to 5 years, before you can keep your employer’s investment. Should you decide to leave your employer prior to fulfilling the vesting period, all or a portion of their contribution will be deducted from your account value. Companies vary in these requirements, so contact your Human Resources department for their specific prerequisites.
- A 401(k) is a great way to reduce your taxable income. The money contributed to your 401(k) is untaxed, which lowers your overall income. Although at first this seems detrimental, a lower income potentially means a lower tax bracket, so you could end up paying fewer taxes to Uncle Sam. For example, if you typically receive $2,000 per paycheck and you put $100 dollars into your 401(k), you will only pay taxes on $1,900. Yet once again, there is a catch: the government charges a 10 percent early withdrawal penalty if you take any money out of your 401(k) account before the age of 59 ½, so try and wait until then. Even after 59 ½, they require you to pay taxes to retrieve your money, but at a smaller tax rate due to your lower income. Just don’t pull all of your money out at once, because what you take determines your “salary” and, consequently, your tax bracket.
- Through the years, your 401(k) builds continuously with compounding interest. In the beginning, you earn interest solely on your original investment, but afterward, you also earn interest on that interest. Although this amount may seem insignificant, over the years, it can grow exponentially. For example, if you invest $100 with an annual 10 percent interest rate, you’ll have $110 after one year. The next year, you earn interest on the $110, giving you $121 after Year 2. This keeps quickly growing and in the long run can mean big bucks. Now add the interest from your employer’s matching contribution, and your 401(k) could be rolling in the dough! Use this 401(k) calculator to determine how much your investment would return after a certain amount of time.
- Your retirement plan is not necessarily lost when switching jobs. If your new employer has a 401(k), you can transfer the plan, but make sure the rollover checks are made out to your new plan administrator and not yourself; otherwise you may be susceptible to tax penalties. If your new employer does not have a 401(k), or has a waiting period for eligibility, most previous employers allow you to leave the money in their plan as long as you have a minimum $5,000 investment. If none of these options are available, you may open a rollover IRA at any bank or financial institution, allowing you to invest your funds in any stock or mutual fund. When thinking about leaving your job, take these options into consideration and contact your current and potential employer’s Human Resources department to arrange for your 401(k).
The money you put in your 401(k), and your employer’s matching contributions, can add up quickly. With the compounding interest gained from these investments, your retirement plan can grow exponentially. As long as you don’t take out money before the age limit, or all at once, your 401(k) can set you up for a fabulous future: one without an 8 to 5 job where you can still live life comfortably. So utilize this benefit wisely, and enjoy the after-retirement explorations and vacations that your planning has awarded you!