Even though the average American doesn't have a 401(k), it's still one of the most effective retirement savings tools out there. If you're not familiar with how 401(k)s work, here are the answers to some of your most pressing questions.
1. Why should I contribute to a 401(k)?
At first glance, the idea of funding a 401(k) may not hold much appeal. After all, you're agreeing to take a chunk of your earnings and lock it away for what could be several decades' time. But in reality, there are multiple benefits to saving in a 401(k).
For one thing, you'll get an immediate tax break for contributing, which is something a regular bank or brokerage account won't give you. Say your effective tax rate is 25% and you opt to put $5,000 into your 401(k) during a given year. In doing so, you'll automatically knock $1,250 off that year's tax bill.
Another good reason to fund a 401(k) is that most plans offer a decent range of investment options that will help you grow your money. Imagine you contribute $300 a month to your 401(k) over a 30-year period. At the end of the day, you'll have put in $108,000 of your own money. But if you invest those contributions and earn an average annual 7% return (which is a few points below the stock market's average), in 30 years' time, you'll have $340,000 in that account, which is far more than the $108,000 that came out of your pocket.
2. How much can I contribute to a 401(k)?
The amount you're allowed to contribute to a 401(k) depends on your age. For the current tax year, workers under 50 can put up to $18,000 into a 401(k). Those 50 and older, however, get a catch-up provision that raises this limit to $24,000. Because 401(k) contribution limits can change from year to year, it's important to keep current on this information to avoid losing out on a critical savings opportunity.
3. When can I access the money in my 401(k)?
The purpose of a 401(k) is to provide income in retirement, and so you're not allowed to access the money in your account until you turn 59 1/2. If you do remove funds from your 401(k) before 59 1/2, you'll face a 10% early withdrawal penalty on the amount you take out. You'll also be subject to taxes on your withdrawal, though the same would hold true if you were to wait until 59 1/2 to start taking distributions.
There are, however, a few exceptions. You can withdraw funds from a 401(k) before age 59 1/2 and avoid a penalty if you use the funds to cover medical expenses that exceed 10% of your adjusted gross income. You can also get at your money early if you become permanently disabled. In addition, in some situations, you may have the option to borrow money from your 401(k), but you should really regard that as a last resort.
4. Are 401(k)s better than IRAs?
To say that 401(k)s are better than IRAs would be somewhat misleading, because IRAs offer certain benefits that 401(k)s do not. For example, IRAs tend to offer a wider range of investment options than 401(k)s, so if you opt for the former over the latter, you might have an easier time minimizing your investment fees while maximizing growth. Furthermore, IRAs allow you to take penalty-free withdrawals before age 59 1/2 to buy a first-time home or pay for college, whereas 401(k)s do not.
On the other hand, 401(k) plans offer much higher annual contribution limits than IRAs. With an IRA, you'll be limited to $5,500 a year if you're under 50, or $6,500 if you're 50 or older, but as we just learned, you can contribute much more to a 401(k). Another benefit of 401(k)s is that companies that sponsor them also tend to match employee contributions to a certain degree. In fact, an estimated 92% of employers with 401(k)s offer this option. You won't, however, get the same sort of free money with a traditional IRA.
Finally, though funding an IRA is far from complicated, 401(k) contributions are just about as seamless as things get. All you need to do to fund your 401(k) is tell your employer how much money you wish to have deducted from each paycheck, and your payroll department will take care of the rest. With an IRA, it's up to you to set aside money and make sure it lands in your account, thus opening the door to temptation rather than savings.
All that said, 401(k)s and IRAs aren't necessarily mutually exclusive. You can, in fact, contribute to both types of account at the same time. Just keep in mind that if you have a 401(k), depending on your income, you may not get a tax break for putting money into an IRA.
Now that you know a bit more about 401(k)s and how they work, it pays to start funding your account as soon as possible. Though a 401(k) isn't your only option for setting money aside for the future, if your employer offers a plan, you'd be wise to take advantage of it.
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