For thousands of Americans, a 401(k) plan is the only real connection they have to the stock market. Some people have hundreds of thousands or even millions of hard-earned dollars invested in a 401(k) and still understand very little about how the plan works. Financial advisors often recommend investing as much money as possible in 401(k) plans because of the many investment advantages they provide. However, investors need to understand what their 401(k) actually is and how it works to unlock its full power. Here are seven things you need to know about your 401(k).
- 401(k) Plans Are Tax Havens
Most of the biggest financial advantages of 401(k) plans are related to the tax advantages they provide. Income taxes take a huge bite out of career earnings, but 401(k) contributions are tax-deferred, meaning investors don’t pay taxes on their invested earnings until they withdraw them from the 401(k) account. There two benefits to this tax-deferred structure. First, Americans can earn capital gains on that income over time prior to paying taxes on it. Second, waiting to pay taxes on income until after retirement typically ensures that income will be taxed at a lower rate.
- Annual Contributions Are Limited
Americans under the age of 50 are only allowed to contribute $18,500 per year in a 401(k) plan. However, that annual contribution limit is raised to $24,500 after the age of 50. The IRS periodically adjusts these limits to adjust for inflation, so it’s important to keep an eye on any changes. Both limits were just raised by $500 in 2018. This year, Americans who wish to max out their $18,500 annual contribution will need to set aside roughly $1,541 per month, or $356 per week, of their pretax income.
- Employer Matching Is Free Money
Many companies incentivize employees to contribute to their 401(k) plans by offering contribution matching plans. Employers typically match a certain portion of an employee’s total 401(k) contribution up to a percentage of his or her total income. For example, a company may match 100 percent of contributions up to 3 percent of annual income. In that scenario, a person earning $50,000 per year who contributes $1,500 annually to a 401(k) would get an additional $1,500 from his or her company as well. There’s essentially no difference between taking full advantage of that matching plan and getting a $1,500 pay raise.
- Your Investment Options Are Flexible
Employers typically offer employees at least a handful of different 401(k) investment plans that have different risk-reward balances and a variety of investment strategies. While 401(k) plans may not offer the same type of flexibility as an individual trading account, choosing the appropriate plan can have a meaningful impact on the type of long-term returns investors get from their 401(k)s. Identifying the subtle differences in allocation and balancing may seem unimportant, complicated and boring, but understanding these differences and choosing the best plan for your personal retirement goals is critical.
- 401(k) Plans Aren’t Free
Unfortunately, 401(k) plans are…
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