Most of us can agree that “401k” is not a very exciting topic. True. But, if you don’t want to work your whole life, it is important. Everyone has probably heard of a 401k, but let’s break it down so you can actually understand it (It’s actually pretty easy). If you are a teacher, you work at a hospital, church or non-profit you may have a 403b account, which is very similar – so read on…
A 401K is technically “an employer sponsored defined contribution plan in the United States (this has a defined contribution amount invested, but gives no guarantee as to what your benefit will be upon retirement).” What the hell does that mean? It means that every time you get paid, you elect to have the company withhold some money from your paycheck and deposit it in some sort of investment.
The 1st Benefit
Often, your company will even kick in a little extra on top of what you invest (an example policy would be…company matches 50% up to 6% of gross pay – so if you make 10,000 in a pay period and invest the full amount $600…the company will kick in an extra $300 – THIS IS FREE MONEY!). Free money is good. Not investing in your 401k is like giving away money.
So the first benefit is free money. There is one more benefit…no taxes!!! (well, not yet…) The money you decide to invest will be taken out of your gross pay. You don’t have to pay taxes until you take the money out of the 401k, which is probably after you retire. Once you retire, this basically replaces your income, so it will be most likely a much lower tax rate than it would be it currently is for you.
One other feature of a 401K is that many employers let you “borrow” money from your 401k for a small list of reasons, like buying your first house.
What if you change jobs or get fired?
In the event you get fired or you change jobs, you will not lose the money that you invested! Sometimes, if you are not “vested” you could lose the interest that you made on your investment, but you won’t lose what your actual investment. If you change jobs, your money can be moved into your new employers 401k (if they have one) or else you can be move it into an individual IRA or another investment vehicle. If for some reason you hit financial difficulty, there are ways to withdraw the money early with a small penalty.
How much should I put contribute???
At a minimum, you should contribute up to the maximum amount that the company will perform some sort of matching on. This is free money, if you do not find a way to do this, then you are really hurting yourself financially.
Let’s say you make $100,000/year. If you were a and employee at the company explained above (company match of 50% up to a 6% contribution), over the course of the year you would contribute $6,000, and the company would match that with an additional $3,000. This is $3,000 dollars of free money.
There is a limit on how much you can deposit in a 401k in a given year ($17,000 for 2012). It should also be noted that for some highly compensated employees there could be some additional limitations. Your human resources or benefits department should be able to provide you with information if needed.
Okay – I’m convinced to contribute? What do I invest in?
401k plans typically allow employees to select from an assortment of mutual funds, certain stocks (often times the stock of your employer), bonds, and money market funds. Selecting your allocation can be daunting to someone that does not have finance experience or education.
My general advice would be to discuss this with a friend or colleague who is educated in finance. Another good way to get some suggestions is to go to an investing forum, read some investing literature, or just search the internet. There really are some great sources of information on the web (blogs, forums, and investing company free materials). Just remember, investing is highly personalized and there are no hard and fast rules. There are a ton of factors to consider: age, risk aversion, financial situation, standard of living, family, debt, credit score, and many more. I would also highly recommend seeking out some real professional advice from a CFP (Certified Financial Planner…this is the most well respected financial planning designation).
Once you put the money in…sit back and let it grow. Constantly checking the value of investments is an easy way to drive you insane, but you should keep an eye on it. Make sure you have regular updates with your financial adviser to update them on your overall situation.