Planning for retirement can feel like an enigma: You recognize the importance, yet you’re unsure where to begin.
The key is to initiate contributions as soon as possible, even if it’s just a small amount each month. This can significantly impact the quality of your life after you retire.
Here’s what you ought to understand:
What is a 401(k)?
A 401(k) is a retirement savings plan sponsored by your employer that allows you to contribute directly from your paycheck. Its designation originates from the section of the IRS tax code that permits it. For employees of nonprofit organizations, religious entities, and educational institutions, the counterpart is a 403(b), while government workers—and occasionally independent contractors—can consider a 457(b) plan.
Enrolling in a 401(k) or a related employer-sponsored plan offers a convenient way to save for retirement, often requiring minimal thought, according to Garrett Prom, CFP®, EA, CRPC®, founder of Prominent Financial Planning LLC based in Austin, Texas.
“It becomes quite automatic, and typically, individuals hardly notice that deduction as much as they would if they were writing a check,” he suggests.
How does it operate?
Your HR department or employee handbook should inform you whether your organization provides the option of contributing to a 401(k). Upon enrollment, you will select a percentage of your earnings to allocate during each pay cycle. This is termed “salary deferral,” as you’re electing to defer your paycheck until retirement rather than receiving it immediately. Your contributions are taken out before federal income taxes are deducted but will be subject to Social Security, Medicare, and federal unemployment taxes.
Some employers offer a “match,” which means they will contribute to your 401(k) based on your own contributions, providing you with additional funds to enhance your savings. According to Steven Podnos, M.D., CFP®, principal of Wealth Care LLC located in Merritt Island, Florida, maximizing the percentage of your salary that your employer will match is crucial for effective retirement savings.
“Ensure you are deferring enough to receive every dollar in matching contributions available to you,” he notes. “The returns can be exceptional.”
For instance, if your employer matches contributions to your 401(k) up to 3% of your income, and you earn $40,000 annually, that translates into a $1,200 contribution from your employer, provided you contribute at least that amount. When completing your 401(k) documentation, opt to contribute 3% of your salary, resulting in a total of $2,400 in annual retirement savings. Keep in mind that some employers may only offer a 50% match, requiring a 6% personal contribution to secure a 3% employer match.
Where is my 401(k) money invested?
Your 401(k) isn’t a static pool of funds that simply accrues interest annually. It’s invested based on your chosen allocation, which could be in stocks, bonds, or a target-date fund that adjusts its investment profile as you near retirement. The allocation of your funds and the associated risk level will determine your potential rate of return and how much your assets will grow over time.
How do I select investment options for my 401(k)?
The variety of investment options in your 401(k) plan can be daunting, particularly for those unfamiliar with the choices. It’s wise to thoroughly review all available options, conduct your own research online, and consult with your plan administrator or broker for guidance.
There are established strategies you may consider as well. Generally, stocks are regarded as higher-risk investments but typically offer better returns over the long haul. “You won’t find a better long-term performance than stocks,” states Podnos.
If you’re younger, you have a greater capacity to engage in primarily stock investments. For individuals in their twenties, Podnos recommends considering a low-cost index fund that mirrors the fluctuations of the S&P 500 index, ideally one with annual maintenance fees below 3%, and a diverse portfolio that includes stocks from around the globe.
When can I access my 401(k) funds?
You may withdraw from your 401(k) without incurring penalties once you reach the age of 59½. Withdrawals before this age typically incur a 10% penalty, albeit with exceptions, such as the “rule of 55.” Regardless, any withdrawal will be subject to income tax on the contributions and earnings based on your current tax bracket. Since many retirees often have lower incomes, it can be advantageous to delay withdrawals.
Additionally, specific company policies dictate when you can begin contributing to your plan and the fate of your contributions upon leaving. For example, if you are not “fully vested” in the employer’s matching scheme when you terminate your employment, you may not receive the entirety of the employer’s contributions.
Should I really prioritize retirement savings at this moment?
Absolutely! The magic lies in compound interest. Rather than receiving a constant interest rate year after year, the interest you earn will grow based on your account balance. Thus, the more you contribute, the more interest you accrue.
For example, over the past decade, the average annual growth of the stock market has been approximately 10%. This figure can serve as an estimated return rate for a 401(k) invested heavily in stocks.
Curious about your potential earnings? Utilize NerdWallet’s retirement savings calculator to explore various savings scenarios.
It might just convince you to start saving… immediately.
