Most of us dream of retirement as soon as we join the workspace, but do you know how to enjoy your retirement to its fullest? Though most of us know that a 401k is synonymous with retirement, we do not know it entails. Well, come along with us to learn more about it, because if you are a Gen Z like me, you most likely don’t know what it means because school hasn’t prepared us for real life.
What is a 401k?
It is a retirement and investment plan that your employer sponsors. It allows you, the employee, a tax break on the money they contribute and will enable you to put aside a percentage of your pre-tax salary toward your retirement plan. The percentage allotted is directly deducted from the employee’s paycheck and is invested in your chosen fund. It has a maximum annual limit of $19500 for 2021 if you are below 50 and if you are 50 or older, the limit is $26000. However, you should know that not all employers offer a 401k plan.
How does it work?
It is a benefit that is offered by employers that ensures that employees have a retirement fund. The employer decided on a fixed percentage deducted directly from the employee’s paycheck and is invested in their 401k account. You can choose where you invest your 401k from a select list of investments like stocks, bonds and mutual funds. Most financial institutions advise you to invest the maximum amount in your 401k plan or as close to it each year as this will make your retirement plan heftier.
As most of us do, if you like free money, you should invest in a 401k if your employer provides it. Most employers offer to match their employees’ contributions to their investments. That is, they either invest a dollar for every dollar you invest or 50cents for every dollar you invest. This means if you invest $8000 a year in your 401k plan, and your employer provides an additional 50% of your investment, that means you are gaining $4000 for free. If that is not an incentive to open a 401k account, I don’t know what is.
Tax breaks
A 401k plan is the gift that keeps on giving. The money you contribute is pre-tax. That is, you pay no tax on it until you withdraw it when you retire. It also doesn’t count as income; the money you invest in your 401k plan is not considered earning and is not counted in your tax each year. This could mean that you are in a lower tax bracket and don’t have to pay as much tax. This may look like tax fraud, but it’s 100% legal, and you should use the system to your advantage. Another thing about this retirement plan is that it is tax-deferred, unlike any other investment. In a regular investment, your gains and dividends would be taxed, but with a 401k plan, your money isn’t taxed as long as it stays in the plan. This investment cornucopia allows your earnings to earn earnings. Even if your finances take a turn for the worst, your 401k is safe and your creditors can’t claim it. This is because you are protected by the ERISA or the Employee Retirement Income Security Act of 1974; this is a fail-safe if everything goes awry.
What happens to your 401k if you change jobs?
Well, worry not, because there are a few options at hand. We recommend a 401k rollover, where you either transfer your funds from your previous employer to an IRA or an Individual Retirement Account, or you can join the 401k plan of your new employer. You can always cash it out, but if you are below 55.5 years, you will lose a good portion of money because of penalties, income taxs and a 10% withholding fee. This should be your last option as it drains a lot of money out of your account.
Remember, it’s never too early to think about the future; investing in a 401k will make your retirement more enjoyable. Sound off in the comments section below and tell us if you plan to open a 401k account.