A 401K is a retirement investment plan offered through your employer. You will contribute a percentage of your pre-tax income and it will go directly into your account each paycheck. You’re able to choose the percentage of your paycheck to be deposited and can adjust accordingly. You will contribute into a variety of mutual funds, bonds, and other investment choices (different for each employer). As the income is pre-tax you won’t be able to withdraw until retirement age 65 without a hefty early withdrawal fee.
Once your Emergency Fund is set, the next step is to contribute to your 401K. Many employers will match a percentage or dollar amount of your contributions. If your employer does offer an employee match make sure you contribute enough to receive the full match. This is free money!
Let’s use an example:
Employer Match: 4%
- Your 401K Investment: $5,200/year
- Company Match: $2,600/year (4% x $65K)
- Total Annual Investment: $7,800/year ($5,200 + $2,600)
Your employer just gave you $2,600 for investing for retirement! Essentially you made a 50% return instantly, not bad considering the market has historically returned 7-9% annually.
Even if you are actively paying off high interest debt (such as a credit card) investing in your 401K is crucial. As your employer matching funds are risk-free, guaranteed returns that are almost always higher than your debts.
When you contribute to both a Roth IRA and a 401K/403B you are taking advantage of the two biggest tax savings accounts. These accounts have tax advantages that help your savings grow faster and larger than they would in a non-tax-advantaged account. The more you contribute to your retirement savings accounts each year, the earlier you’ll have the option to retire.
Once you retire it’s impossible to know what tax bracket you’ll be in at various stages in your retirement or what the tax rates will be in the future. By having a 401K and Roth IRA you will have diversification within your retirement accounts.
Additional 401K Facts
- $18,000 is the maximum annual contribution limit (the amount you can contribute, employer match is additional)
- Certain instances you can withdraw the money early (i.e. medical expenses, avoiding foreclosure, 1st time home-buying)
Once you feel comfortable with contributing to a 401K/403B check out my full post here to understand your investment options and ensure you are picking the lowest cost options & becoming diversified.