Understanding 401k and the Affects It Has on Your Financial Future

A 401(k) is a retirement savings plan facilitated by an employer and managed by a third-party financial institution. Employees choose what percentage of their income they want their employer to contribute on their behalf. The money is deducted from the employee’s paycheck just like tax withholding.

This method of retirement savings has helped millions of American workers prepare for retirement. It is far easier to save when you don’t have to make a conscious effort to do it on a regular basis. This set-it-and-forget-it approach to retirement savings (and investing) frequently leads to better outcomes in the long run.

What Is a Tax-Advantaged Retirement Plan?

Many retirement accounts offer some kind of tax advantage, including 401(k)s. Workers who use traditional 401(k) plans are making pre-tax contributions. That means the percentage of your income that’s being deposited into your 401(k) doesn’t have any taxes removed from it. At the end of the year, you don’t have to pay taxes on your 401(k) contributions, even though technically all those contributions come from your income.

Everyone eventually does have to pay tax on their 401(k) disbursements (distributions) and withdrawals, but those aren’t intended to start until you’re 59 ½ at the earliest. Technically, you can withdraw money from your 401(k) whenever you like, but there is a steep IRS penalty on top of normal income taxes.

Although there are exceptions that will exempt you from early withdrawal penalties, they won’t exempt early withdrawals from income taxes.

How Do You Make Choices in Your 401(k)?

Although there are self-directed 401(k)s that can be used like any other brokerage account or IRA, most retirement savers who use 401(k)s are most likely to be given a handful of potential investment choices.

Your Risk Tolerance

Before making decisions regarding 401(k) investment picks, it’s important to understand one’s own risk tolerance. Some investment options carry significantly higher risk but also more growth potential. Others are quite low risk but will also grow at a slower pace than the riskier investment options.

As a rule of thumb, most young retirement investors start out with high-risk investment strategies and gravitate to lower-risk options the closer they get to retirement. Protecting the value of your 401(k) is often more important than growth by the time you reach retirement.

Types of Investments

Most 401(k)s allow you to invest in specific mutual funds. These funds often include an S&P 500 fund, a large-cap fund, a mid-cap fund, a small-cap fund, international investment funds and funds specifically intended to be large-growth and high-risk as well as low-growth and low-risk, among others.

Many 401(k) providers also offer more hands-off investment options where you simply choose a preferred investment approach, and the company manages the rest. For example, you may be able to set your retirement age and adjustments will be made to your 401(k) portfolio without the need for you to ever intervene. These options automatically alter your risk exposure and grow your money without you ever needing to rebalance your fund allocations.

How you manage your 401(k) is a personal choice. Some people who don’t pay much attention to the market or investments may prefer a more turnkey approach. Others may want to micromanage their options and adjust their funds frequently.

Matching Funds and Company Stock

Many companies offer 401(k) matching as a hiring incentive and employee benefit. These matching funds are frequently in the three to six percent range. What that essentially means is an employer will match an employee’s contributions up to that percentage of their salary.

If you made $60,000 and set your contribution to six percent to maximize your employer match, you’d be putting in $3,600 a year and your employer would be putting in $3,600 a year for a total contribution of $7,200 a year.

Many employers match in the form of company stock, so they would technically be putting $3,600 of company stock into your 401(k) each year. In most cases, you are free to sell the company stock and move the proceeds into the other funds.

Should You Maximize Your Employer Match?

Some people believe that failing to maximize your employer matching funds is no different than leaving money on the table. However, every person is different. Some retirement investors believe they can beat their 401(k) investment options on their own through a self-directed brokerage account or some other investment strategy (like real estate). Others may simply not have the room in their budget to sacrifice that much of their check every pay period.

Do You Want to Maximize Your Retirement Savings?

Are you worried you haven’t saved enough for retirement? Are you wondering if there are better ways to grow your nest egg? Have you been saving in your 401(k), but aren’t sure it’s enough to maintain your quality of life during retirement?

You don’t have to be in your 50s or 60s to have those questions, and it’s never too early to start planning for your future. Contact Fullerton Financial Planning today at (623) 974-0300 to learn more about possible retirement investment strategies.