What is a 401(k)? – Maximize Your Retirement Savings
Pensions used to be the primary method of funding your retirement. After working, say, 30 years for your employer, you could spend the rest of your life chillin’ on a beach (like Cash Cat) while your previous employer continued to sign your checks.
Well, these days, only 17% of workers in the private sector have access to a pension. The times they are a-changin’.
Rather than a pension, it’s more common for employers to offer a 401(k). A 401(k) is a great way to save for retirement and take advantage of some tax savings on your path to Financial Liberty. This post will go over the details of a 401(k) and how you can maximize your benefits and savings.
What is a 401(k)?
A 401(k) is a defined-contribution retirement plan, which gets its name from section 401(k) of the tax code where its guidelines, standards, and funding rules are defined. As opposed to defined-benefit retirement plans, like pensions, the 401(k) is employeE-funded, rather than employeR-funded.
Wait! You mean I have to save for retirement myself?
Yup. But no one will ever be as good of a steward of your finances as you will. That’s what Financial Liberty is all about. I will show you how to use the tools available to set yourself up for the most financial success.
How Does a 401(k) Work?
Every time you get paid, you can elect to have a certain percentage of your income go into your 401(k). It’s simple and automatic.
Also, while pensions and defined-benefit plans are becoming a thing of the past, many employers offer a 401(k) match, which means they will contribute money to your 401(k) as well! It’s pretty typical to see something like a 50% employer match up to 6%. This means if you contribute 6% of your income to your 401(k), your employer contributes an amount equal to 3% of your income.
If your employer offers a match, then maximize it. It’s free money.
Even if your employer does not offer a match, it is still wise to contribute to your 401(k) because it offers tax advantages. I explain how these tax advantages work in my next blog post.
How is the Money Invested?
Typically, your employer will contract with a company to manage your 401(k) and they will have some set options. A 401(k) is not like a brokerage account or IRA where you can pick and choose from any equity on the market. Instead, there are usually a few dozen options that are some type of managed fund, like a Target-Date Fund.
In deciding what option is best for you, there are two things you’ll want to consider:
- How long until you retire
- If you’re young, you’ll want something more aggressive. If you’re approaching retirement you’ll want something more conservative. Risk tolerance is personal as well.
- The expense ratio of the fund
- There are some good ones, and some not so good ones. One of the funds in my 401(k) has an expense ratio of 0.09%. That means for every $100,000 invested, I pay only $90 in fees per year. Though, if that expense ratio was 1.0%, I’d be paying $1,000 per year!
As a side note, you also want to know what fees the broker or account manager is charging. A study by Yale found that 16% of 401(k) accounts had fees that were so substantial they outweighed the tax benefits of the account.
Alternatives to a 401(k)
Not every employer offers a 401(k), but sometimes they may offer an account with similar tax advantages and usually some level of match. For example, some non-profit employers, public education organizations, and hospitals offer a 403(b). If you are a federal employee or in the military, you will have a TSP instead. There is also a 457 plan.
These plans all have very similar features and tax-advantages. Find out what type of plan your employer offers and make sure you’re using it to invest in your financial future. You will be able to save and invest more money because of the tax advantages. And again, if your employer offers a match, THIS IS FREE MONEY!