401k – Everything you need to know
Planning for your retirement should start now, when there’s still time for you to save and still have the energy to work and earn money. The earlier you start saving and keep saving, the higher the possibility of you retiring with the best lifestyle possible. You can even retire richer than you were while working with the right investment strategy.
One of the many ways that you can ensure a stress-free retirement is through a 401(k). Without a doubt, you’ve heard of it before, and you may be saving money in a 401k. But what do you really know about your 401k except that it’s a pension plan?
Time to educate yourself. Continue reading to become financially literate about your 401k and retirement.
What is a 401k?
A 401k is an employer-sponsored retirement savings plan, where you save and invest a part of your paycheck before taxes are taken out. This means, if you allocate 7% of your income to your 401k, it will be deducted from your gross earnings, which will be higher than if the 7% was deducted after taxes.
How much should you set aside for your 401k?
Financial experts agree that you should save at least 10% of your paycheck for your retirement account. You can choose to go lower, of course. But the more you allocate, the more money you can enjoy in the future.
Where do your savings go?
The money you invest in your 401k can be spread through various products, or in stocks, money market fund and bonds that comprise a spread of mutual funds. You have full control of how your money is invested, which would require a certain level of financial literacy or, at least, basic knowledge of different investment products.
- Stocks are a share in the ownership of a company, representing a claim on a corporation’s assets and earnings. How much you earn will depend on the amount of stocks you own.
- Money market funds are a relatively safe investment in short-term securities, such as the US Treasury bill. They’re as safe as bank deposits, but with a higher yield.
- Bonds are a form of debt investment, where your money is loaned to the government or a company.
The most popular option, however, is target-date funds that combine stocks and bonds. One is high risk, while the other is low risk. What is great about this option is that it becomes more conservative, as you reach your retirement age. This makes practical sense, since you don’t want to risk your savings when you’re nearing the time that you’ll need them the most.
Rules governing a 401k
As it is a subsection of the Internal Revenue Code, a 401(k) is regulated by the Internal Revenue code, and the government sets the rules on contribution and treatment of retirement accounts.
- 401k savings are tax-free. Tax will only apply upon early withdrawal.
- For the 2016 tax year, everyone could contribute $18,000 into a 401k
- If you are over age 50, you need to make an additional contribution of $6,000 to bring your total contribution to $24,000.
- You must keep your funds invested in 401(k) until you reach the age of 59 and ½.
- Withdrawing early from your pension plan will incur taxes and penalties, unless you meet an exception.
Tax fees and penalties
If you cash out early from your 401k, you will have to pay a 10% early withdrawal penalty. This is on top of the federal and state income tax that you need to face.
Scenario 1: You withdraw $50,000 from your pension, at an income bracket of 20%.
- Withdrawal: $50,000
- Income Tax Owed: $10,000
- 10% Tax Penalty Owed: $5,000
- Total Tax and Penalty: $15,000
- Net Withdrawal Amount: $35,500
30% of tax and penalty is cut from your withdrawal.
Scenario 2: You withdraw $30,000 from your 401k, at an income bracket of 25%.
- Withdrawal: $30,000
- Income Tax Owed: $7,500
- 10% Tax Penalty Owed: $3,000
- Total Tax and Penalty: $10,500
- Net Withdrawal Amount: $19,500
35% of tax and penalty is cut from your withdrawal.
Exceptions to the early withdrawal penalty
There are always exceptions to the rule, and you don’t have to pay tax and penalties if you cash out from your 401(k) for the following reasons:
- Medical costs exceeding 7-1/2% of AGI (Adjusted Gross Income)
- Separation from service at age 55 or older (pensions & 401k but not IRAs)
- Military reservist called to active duty
- Public safety employees separated after age 50
- IRS levy
- Substantially equal periodic payments (SEPP)
- Court ordered spousal payments
- Unemployed Medical Insurance
- Rollovers to another IRA
Think your investment options for your pension plan are limited? You can always rollover your 401k to an Individual Retirement Account (IRA). This option is also highly recommended if you leave a company before your retirement age.
- Rollover 401k to an IRA, if you want to do more and enjoy more of your savings even before you reach retirement
With an IRA, you have access to more investment options, and you get to choose the brokerage firm where you want to roll your funds. This means, you get to select the fees to pay for a broker, unlike in 401k plans where fees are not transparent. You can also withdraw money from your IRA for education expenses, and to buy a house for the first time without facing taxes and penalties.
- Rollover to a new employer’s 401k if you want all your funds in one account, or when your new employer offers better investment options.
- You can also choose to leave your 401(k) with your old employer if the cost and investment options are better than what your new employer offers.
Starting a 401k is entirely up to you. You also get to decide when to start making contributions. But if you want a retirement plan that works to your advantage, you should start early and save more than the recommended 10%. Save for the future, so you can enjoy the kind of lifestyle you deserve – in luxury and style. Believe me. It is possible.