When it comes to your personal finances and creating a long term financial plan, you should consider saving for your retirement. In the United States, 401k plan is one of the retirement savings plan you can use. I am creating this resource to explain 401k in simple terms and help you understand how it works.
In the last couple of months, I have been keen to understand how I can save enough money for my retirement.
If you are like me, you do not dream of working until you are 60 years old or even older. You would want to have enough savings for the time you will stop being actively employed.
In order to have a comfortable and financially stable retirement, you should be able to create a financial cushion. Have a saving nest egg will help you finance your life in retirement.
Planning for retirement starts with thinking about your retirement goals and how long you have to meet them.
You should look at the types of retirement saving accounts that can help you raise the money to fund your future.
A 401k can be a good place to start your journey towards a financially secure retirement. Creating a plan towards your retirement is the first step you should take today.
What is 401k Retirement Plan?
A 401k plan is in simple terms a retirement savings and investing plan that is provided for by employers.
As an employee, you are going to get tax advantages and breaks for the money you contribute to a 401k plan.
401k plan derives its name from a section of the U.S Internal Revenue Code.
Types of 401k Plans
There are two types of 401k retirement and savings plan.
- Traditional 401k Plan
- ROTH 401k Plan
The big difference in these two types of plan is on how they are taxed.
In a traditional 401(k), employee contributions are “pre-tax.” That is, the money is deducted from gross income and no taxes are due on it until the money is withdrawn.
With a Roth, employees pay the income taxes up front but can make withdrawals tax-free
How 401k Works in Simple Terms
In simple terms a 401k plan is an employer-based retirement savings and investment plan in United States.
Now that I have defined what a 401k is and what it means, I would like to explain how 401k works in very simple terms.
The idea is to help you understand how this retirement plan can help you achieve your financial objectives.
When you enrol for a 401k plan that is provided by your employer, your contributions will be deducted automatically from your salary.
He is how I would explain 401k in simple terms – you contribute money to an individual account by signing up for the automatic deduction from your pay check.
Depending on the type of the 401k plan you have, you will qualify for tax breaks when you contribute the cash or when you withdraw it in retirement.
The cash will be saved and invested in funds of your own choosing. You will be able to choose from a number of options that will be provided by your employer.
If your employer matches the same, then you will be contributing much more to your 401k plan.
However, 401k plans have an annual contribution limit of $19,500 limit for 2021. If you are 50 years of age or older, the contribution limit is $26,000.
Contributing to a 401(k) Plan
A 401(k) is a defined contribution plan. The employee and employer can make contributions to the account up to the dollar limits set by the Internal Revenue Service (IRS).
A defined contribution plan is an alternative to the traditional pension, which is known in IRS lingo as a defined-benefit plan.
That is, an employer who offers a pension is committed to providing a specific amount of money to the employee for life during retirement.
In recent decades, 401(k) plans have become more common, and traditional pensions have become rare as employers shifted the responsibility and risk of saving for retirement to their employees.
Employees also are responsible for choosing the specific investments within their 401(k) accounts, from a selection their employer offers.
Those offerings typically include an assortment of stock and bond mutual funds as well as target-date funds that are designed to reduce the risk of investment losses as the employee approaches retirement.
They may also include guaranteed investment contracts (GICs) issued by insurance companies and sometimes the employer’s own stock.
Benefits of Saving and Investing in 401k Plans
401k plans is a good way for you to start planning for your retirement. It is important to plan for the time when you will not be actively employed.
Here are the seven benefits of 401k retirement plan;
- Save for your retirement.
- You get tax breaks and advantages
- Contribution flexibility.
- Time is on your side.
- You can take it with you.
- Easy payroll deductions
- Borrow against your contribution.
You should consider these benefits to join and leverage the 401k plans for your retirement.
7 Benefits of Investing in a 401k Retirement and Savings Plan
One of the best ways for you to save toward your own retirement and ensure your future security is through an employer-sponsored 401(k) plan.
If you are not part of the 401k plan participate, you are missing a golden opportunity to save for retirement while lowering your tax burden on those savings.
Save for your retirement.
This is the biggest benefit of having or contributing into a 401k savings plan.
It is helping you to save for your retirement.
Saving is a key step towards having financial independence and stability.
Related: 17 Practical Tips to Spend Your Salary Wisely
In personal finances, planning for your retirement is important. Helps you to afford your lifestyle when you stop being active in making or generating money.
You get tax breaks and advantages
In a traditional 401k plan, your contributions are deducted directly from your pay check before federal income taxes are withheld.
This is an advantage because contributions are pre-tax. You end up paying less tax because this lowers your total taxable income.
You are going to get the flexibility in your contribution.
It is possible to contribute as much or as little as you want to your 401k account. This depends on your specific plan and the IRS limit.
You also get flexibility to change your contribution levels at any time.
Time is on your side.
When it comes to saving, time horizon is very important.
The earlier you start your 401k savings plan, the better. This gives your money more time to grow.
One of the greatest advantages you get by having time on your side is compound interest. This is when you earn interest on the principal amount of an investment plus any accumulated interest. You earn interest on your interest.
That is why you should start contributing to your 401k plan as early as you can. Compound interest has long term benefits to your retirement saving plans.
You can take it with you.
Another benefit of the 401k retirement plan is that you can take it with you. This is important when you change your job.
The money that you have contributed to your 401k plan belongs to you. It means that if you move into a different company, your plan and earnings are yours.
Depending on your type of 410k plan, you can keep your retirement contribution invested and growing on a tax-deferred basis.
Easy payroll deductions
You can make your 401k contributions automatically by having them deducted from your salary.
This makes saving for your retirement easy and simple. It is a process that is effortless on your part.
It is a good idea that contribution is deducted from your paycheck before you receive the fund. That way, you are not going to miss the money.
Borrow against your contribution.
You should know that some of the 401k plans will allow you to get a loan against your contribution. This is for specific reasons like buying a house or paying for your education.
A loan usually must be paid back with interest within five years, and as long as you remain employed by the company, you can pay it back without incurring any income tax liability.
The interest you pay goes directly into your account.
In conclusion, you should make efforts to ensure you have a retirement plan in place.
As you have seen, 401k retirement saving plan can be an excellent way to start saving for your retirement. You will also get tax advantages for the amount of money you contribute to the plan.
In personal finances, you should ensure you max your 401k contribution. This means saving all the amount of money allowed by the law and by your employer to the plan.
While it is important to rely on your employer-driven retirement plan like the 401k, you should also not put all eggs in one basket.
What this means is you should also take responsibility of your own retirement.
I would expect that you have other ways and accounts where you are saving for your retirement. You should also make investments with a focus on your retirement.
It would be really bad to retire and not have financial stability.
The goal of planning for your retirement is ensuring you have the financial capacity and stability to afford your lifestyle after you retire.