We just started a new financial planning web series called 5 Minute Finance. Where we’ll be talking about different financial planning topics and answering your questions in under five minutes.
Our inagural video is about 401(k)s and how they work. The video is available above, and a written description is available below.
The very first thing we should say about 401(k)s is that if you aren’t sure about the rules, it’s usually a good idea to ask a professional. There are some limits to the benefits of a 401(k) depending on how much you earn, and what other kinds of retirement plans you have. That said, here’s a look at what a 401(k) is and how to use it.
A 401(k) is a type of retirement plan that is given to you by the company you work for. Not every company offers 401(k) plans to their employees though, usually hourly employees at small mom and pop stores won’t offer retirement plans. But if you work for a company that does offer one, and you are eligible to use it, then you are in luck, because these accounts are one of the easiest ways to save for retirement.
A 401(k) account is funded from your salary. Most companies allow you to designate a certain percentage of your pay to go to the 401(k) account. This usually is outlined as a percentage of your income. For example, if you make 100,000 each year, and you designate 6% to be put into your 401(k), then $6,000 will be put in over the course of the year. It will end up being $500 each month.
Some companies offer a “matching” option, where they will offer to match your contributions up to a certain amount. This is an extra incentive to get you to save more money. So for example, a common matching program is for the company to match 50% up to 6% of your income. This might sound a little complicated, but it means that however much you contribute, they will put in an extra 50% of that amount, until you’ve contributed 6% of your income, then they will stop matching it.
For example, if the company has the 50% up to 6% policy, and you make $100,000 a year, then they will match 50% of the first $6,000 that you contribute, which gives you an extra $3,000 each year. Now your account has $9,000 in contributions instead of just the $6,000 that you contributed yourself. You can usually keep contributing beyond the 6% if you want to, but you won’t get the matching boost if you do.
There are some limits to how much you can contribute to a 401(k). They change every year, so it’s a good idea to look up the current limits before you contribute anything to the account. As of right now, an eligible employee can deposit up to $18,000 each year into a 401(k). And someone over 50 years old is allowed to deposit an additional $6,000 more than that. The matching contributions from your company don’t count towards that limit either, so you can get even more in there if they have a good matching program.
One of the biggest benefits of a 401(k) is that, if you qualify, you can defer taxes on the income that gets put into your retirement account. So if you had $100,000 in income for the year, but you put $10,000 into a 401(k), you might be eligible to defer taxes on that $10,000 and so you would be taxed as if you earned only $90,000 for the year. Make sure to talk to a good CPA or financial planner to make sure this applies to you though, because not everyone can take advantage of the tax breaks.
Those are the basics of 401ks, we hope that cleared up some questions for you. And if you have any more questions about any personal finance topics, feel free to send us an email at info@ArbogastAdvisers.com or visit our website at www.ArbogastAdvisers.com. We’d be glad to help you out.