It’s National 401(k) Day! Here Are the Basics To Get the Most Out of Yours
September 5th, 2023
Setting yourself up for success in retirement is necessary to have a more stress-free life later on. 401(k)s are one of the most popular ways to ensure you have funds to live off of in your retirement.
Whether you have a decent knowledge of 401(k)s or are just starting to think about starting one, knowing the basics about them and how to get the most out of your investment is vital.
Most people tend to invest for their retirement in a 401(k) that their employer offers, but that's not the only option you have when creating a 401(k). Let's dive into 401(k)s basics and how you can get the most out of your investment.
There are two basic types of 401(k)s that you can go with. There's a traditional 401(k) and a Roth 401(k). The main difference between these two structures is how you'll get taxed on them.
The traditional structure that most people opt for is one that you sign up for with your employer. When you sign up for their 401(k) program, there's a specific dollar amount or percentage you agree to contribute per paycheck that automatically comes from your check and goes into your 401(k) account.
The amount that you contribute is pre-tax. That means traditional 401(k) structures will reduce your taxable income, but when it's time to withdraw any funds, those will face a tax.
Roth 401(k)s can also be through your employer, but they're not as common as the traditional structure. With this type of 401(k), any contributions you make towards the account are made on income after taxing it.
You won't get any tax deductions for the year that you contribute the money since they're already taxed. Unlike traditional 401(k)s, withdrawals are tax-free.
Which Structure Should You Go With?
Both 401(k) options have pros and cons; which you choose will ultimately depend on your situation and preference. Most people suggest going with a Roth 401(k) because of the tax-free withdrawals and because you won't pay taxes on the contributions in that year.
Besides, there are a few other things to consider before choosing which structure is suitable for you. For those who believe they'll be in a higher tax bracket by the time they retire, a Roth 401(k) tends to be the best option because you'll be paying taxes now at a lower rate but get tax-free withdrawals during retirement.
On the other hand, if you think you'll be in the same or a lower tax bracket by retirement, then a traditional one might be the best option for you. You'll avoid paying taxes for now so you can put more money aside, and when it comes time to withdraw, you will pay taxes, but they'll likely be manageable.
Who You Should Invest Your 401(k) With
If your employer offers a 401(k) program, you should sign up when you get hired or when they allow you to. Doing it this way is a great way to make consistent contributions to your retirement because it comes out of your paycheck before you even see it.
In addition to the money automatically going into your 401(k) account, many employers will offer contribution matching in some way. Regardless of how much the contribution matching is or how long they do it, that's extra money going into your 401(k) that you didn't have before.
For those who are self-employed or whose employers don't offer a 401(k), there are a few options that you can choose. You can open a solo 401(k) retirement plan, a simplified employee pension (SEP), or a Simple IRA. These all have advantages and disadvantages that you'll want to explore to make sure you're making the right decision for your retirement.
How Your Returns Will Look Based on Your 401(k) Contributions
What your return will look like depends entirely on how much you've contributed over the years and any other contributions from employers. That, combined with the current market environment, looks like your return can look different from someone else's when you're ready to withdraw.
If you were to withdraw any funds before turning 59 ½, you'd face a 10% additional tax on top of the taxes you might be paying to take that money out. So, your returns will be lower than the amount in your account.
You'll also need to factor in what age you'll retire when you start dipping into the 401(k) and other factors like how much you contribute from year to year.
Let's look at some examples of people who retire at the retirement age without any other factories affecting their returns.
If you're a 35-year-old with an annual income of $50,000 and have already saved $25,000 in your 401(k), you'll have $868,000 at retirement. That's based on the person contributing $5,000 per year. You can use tools like this one from NerdWallet to see where your returns might be.
How To Maximize Your Return
Those with a 401(k) or interest in opening one should know how to maximize your returns. Some of the best ways to optimize your return are:
Put any extra money you have towards your 401(k)
Max out employer contributions
Don't withdraw any money early
Contribute the maximum amount allowed by law to your 401(k) per year
Planning for retirement can be exciting and scary all at the same time. To make sure you can live as stress-free as possible when it's time to kick back and enjoy your retirement, taking advantage of a 401(k) is essential.
Be sure you're choosing the right 401(k) structure and taking advantage of everything you can to maximize your returns. If you do this, you'll be sitting pretty when you're ready to retire.