The Basics of 401ks
401ks are one of the easiest ways to save money for retirement. And before we get any farther I want to mention that little thing called compounding interest.
So if you don’t take anything away from this blog post, just remember that the earlier you start contributing to your 401k the faster it will grow, and the more you’ll have stocked away for you in retirement and if nothing else, more for your beneficiaries after you pass.
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What is a 401k?
A 401k is an employer sponsored retirement brokerage account. So you and maybe your employer will contribute to the fund and once you have those funds its up to you to put it into the market to grow over the years between when you contribute and when you withdraw.
401ks often come with an employer match so for every percentage of your salary you contribute your employer may contribute as much or part of it. We will get into some examples of matches later on, but let’s continue explaining what a 401k is.
Types of 401ks
There are generally two different types of 401ks. Roth 401ks and Traditional 401ks. These follow the similar pattern of Roth IRA and a Traditional IRA.
The Roth is after tax. So you will withdraw from it and it will not be taxed as income.
The Traditional 401k is before tax. Meaning when you withdraw it is taxed as income in whatever bracket you land in, in retirement.
Other forms of 401ks
A 401k is not the only employer-sponsored retirement accounts. However, it is the most common if you do not work in public works.
So there are things like a 403b which is typically for employees of nonprofits, government workers, and public school employees. These come with their own tax benefits.
Another plan is the 457b and 457f which are for state and local government employees and nonprofit employees/executives.
Investopedia has a fantastic break down of each of these retirement plans. click here
Maximums
If you are just starting out with your career and are new to investing for retirement, congrats! But also you probably wont hit this contribution limit in your first few years. We’ve been investing for 5 years and still haven’t hit that limit.
However, the yearly contribution limit in 2021 is $19,500 between your contributions and your employers contributions. So before you max that out yourself. Do the math to understand how much you want to contribute to have the max employer benefit while not letting them get out free because you maxed it out.
So let’s say that they match up to $4000. You’d want to contribute $15,500 to max it out so then you get the full benefit from your employer.
Employer Matches
Let’s move into employer matches which are one of the best parts of the 401k plans! Often times, but not all employers will match your contributions to a certain percentage of your total compensation.
To make things easy let’s say you have a $100,000 salary and your employer offers a 4% match. They would match your contributions up to 4% of your total salary. So they’ll put in $4,000 into your 401k if you put in at least $4000. So if you put in $5000 they’ll still do the $4,000.
However, if you put in $2000 they’ll only put in $2000.
Now let’s make things a little more complicated. Some employers will do the percentage match at a rate. Again imagine you have a $100,000 salary to make this math easy. The employer has an 8% match at a 50% rate. So they will match your contributions up to 50% of 8% of your salary.
Meaning, if you put in $8000 (8% of your salary) then they’ll do $4000 (50% of the 8%)
Yes, it’s a little confusing but hopefully, you don’t have to deal with that last scenario.
Conclusion
In conclusion, this stuff can be incredibly confusing! If possible and in your budget, getting that employer match is a crucial step in planning for retirement. It’s ‘free money’.
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