Should I contribute to a 401k, and what kind of long term benefits will it provide me? Generally, when a person is asking this question, they already have a good idea of what the answer is. You absolutely should contribute to a 401k if your employer offers it.
This type of retirement account is for someone who isn’t going to touch their investment in the short term. There are substantial penalties for early withdrawal. If you’re in it for the long term to grow your nest egg over the course of your career, this is an ideal tool.
What Is A 401k Plan?
401k plans are tax-deferred retirement plan that is directly tied to your employer. Many companies match up to a percentage of your contributions, so it is wise to take advantage of that.
Employees contribute a portion of their pre-taxed income where it grows until you reach a set timeframe. You do not need to manually transfer money to the account, it is deducted automatically from your paycheck.
Types Of 401k Plans
You may know of the traditional 401k, but were you aware that there are different types of 401k plans? There are actually two types of plans. There are Traditional and Roth 401k plans and your employer will let you know which one they offer, if not both.
Roth 401ks are similar to their traditional 401k counterpart in that you get that employee match (if offered by the company). But the main difference is that contributions are taxed as you are putting money in. This means that it grows tax-free until you are able to withdraw proceeds.
How Much Should I Contribute To My 401k?
The answer to this question depends upon your current financial situation. Not everyone will have the same answer to the question. Certain things like how much you make, how much debt you have, and how much your company matches for the 401k should all be factored into the equation.
If you work for a company that has a matching percentage contribution, it is recommended to put that amount in at the least. If you can contribute more, that is great. You should at least put in the matching amount, as it is essentially free money from the company.
The company match is the baseline contribution, the absolute minimum you should be contributing to the 401k. The contribution limit for a traditional 401k is $19,500 for the year 2020. If you are able to go all the way up to that amount for your contribution per year, that would be recommended. For those age 50 and up, there is an additional $6,500 “catch-up” contribution made available. That would make your total annual contribution limit $26,000.
After you prioritize the matching amount within your 401k, from there, you should probably be looking at investing in a Roth IRA or traditional IRA. Both plans offer tax incentives that can be taken advantage of with a 401k.
401k Withdrawal Rules
You should not contribute to a 401k if you have hopes of withdrawing money in a short period of time (relative to your retirement date). You will not be able to withdraw from this account penalty-free until age 59.5, or you have retired or become disabled. Early withdrawals will be hit with a 10% penalty tax alongside income tax.
If you are in it for the long term, then you will be able to have access to your assets at 59.5 years old. You actually will be required to start to take required minimum distributions by age 72, if you have not started withdrawing already. If you can wait for this age range before you will need this money, you should definitely contribute to your 401k.
Pros And Cons Of 401ks
An employer-sponsored retirement plan, like a 401k, is a great long term investment vehicle. It provides great benefits during and after your career. It doesn’t come without some drawbacks or restrictions that you should be aware of though.
Since a majority of companies in the US are going away from pension type plans, the 401k has become a popular substitute as their primary retirement plan vehicle. There are many reasons why 401k’s should be included in your retirement planning strategy. The main benefits include:
- Convenience: You do not have to worry about doing anything manually each pay period since funds are deducted from each paycheck
- Tax Incentives: Contributions in the plan grow tax-deferred until distributions begin. Also, contributions can be deducted to lower your taxable income.
- Match Incentive: Employer matches to your retirement plan is free money
The 401k retirement plan can be great if you do not need funds in the near term. If you expect returns on investments prior to retirement, you may need to seek out another option. Shortfalls of 401k plans include:
- Penalties: Early withdrawal are hit with a 10% penalty tax on top of income taxes
- Hidden Fees: Administration, management, and investment fees depending on the choices made available
- Limited Investment Options: Investments inside your plan depend on what your employer agrees to offer
Verdict: You Should Take Advantage Of A 401k Plan
If you wish to create your retirement nest egg with a little boost from your employer, a 401k is a good plan. There are several tax-related benefits that you get just by making contributions to your account. It is easy to maintain, you just set a percentage of your income and it does the rest.
You cannot however use this as a bank account and try to withdraw money as you see fit. It is not as flexible as other retirement accounts, and there may be penalties associated with taking money out. With this being said, the verdict here is that generally a 401k is a good idea based solely on employer matching.