Before you land your first real job that offers a retirement plan, such as a 401(k), you need to learn about its features and start planning for your own future. A 401(k) is a retirement savings plan, sponsored by your employer. It lets workers save and invest a piece of their paychecks before taxes are taken out. The amount before those taxes are removes is called pretax earnings. You don’t pay taxes on the money you contribute or the growth in that money until you take it out of your 401(k) account much later in life so that is a big benefit. You can elect to have a certain percentage of your paycheck deducted each pay period, and that money is contributed to your 401(k) account. Your account has your name on it, and you control it and how it is invested over time. Most plans offer many choices of mutual funds to invest in. Those are composed of stocks, bonds, and money market investments. How you invest the money in your account is up to you.
Learning how a 401(k) plan works is very important. That’s because planning for your own retirement is your responsibility. In the past, workers could count on pension plans and social security payments to live a comfortable retirement. Not these days. It is now up to you, and no one can plan for your financial future except you.
A company match is also a very valuable feature to the growth of your assets. The company match is the amount that your company agrees to deposit into your account for your benefit. Many companies will match the money you contribute to your 401(k) account, and will do so up to a certain percentage of your income. The average match offered by companies as a benefit is 3 percent of your annual payroll earnings, but your company may offer a higher or lower percentage, so be sure to find out how much is offered. If you contribute 3 percent of a $50,000 salary into your 401(k), or $1,500, then your company will add another $1,500 into your account. You can add more than that $1,500 yourself, but the company won’t match beyond that 3 percent. Always contribute enough to your account each year to at least receive the full company match. It is free money! And that company match will make a huge difference in the growth of your account balance over the many years before retirement.
There are contribution limits for 401(k) accounts, and for 2019, the maximum that you can add to your account in the calendar year is $19,000, not including your employer’s match.
Why do we call it a 401(k)? In 1978, a chapter of the federal tax code (Chapter 401) was updated to include the creation, idea, and outline for these types of retirement accounts. The new 401(k) idea was an afterthought at the time, but soon grew quickly to be the main retirement planning vehicle for United States employees.
What if my company goes out of business? Not to worry as your 401(k) account and its investments are separated from your company’s finances and debts, so even if your company hits hard times, your retirement savings are segregated and safe, and you can take your account to your next employer, untouched by your old employer.
How is a 401(k) different from a pension plan? Back in the old days, many companies used pension plans to attract employees and help them retire with a defined income until their death. With these so-called defined benefit plans, an employee’s income after retirement was set in stone, and the employee knew what it would be and could depend on it for a secure retirement. A company would contribute an amount to the pension plan every year and would invest the funds to grow assets over time, and then pay out some of the funds every year to retired employees. In 1979, 32 percent of employees in the United States were part of a pension plan. However, today far fewer employees benefit from a pension plan, and are mostly government employees (police, teachers, firemen) and members of trade unions. Company usage of these pension plans have declined considerably over the years, and the responsibility for saving for retirement has been shifted to the employee through plans such as the 401(k).
A 401(k) plan is considered a defined contribution plan where only the amount of money added to a retirement account is known and with the ending account value dependent on the investments used, the amount added to the account over the years, and the amount of time the assets have a chance to grow. The amount contributed to the account is known, but the resulting financial benefits to the account owner is not defined as in a pension plan.
The days when pension plans secured a comfortable retirement for many employees are over, and these days it is an employee’s responsibility to plan for his or her retirement, and to add and invest funds on his or her own. And beginning 401(k) contributions when you secure your first job can make a huge difference down the road.
For instance, let’s say you earn $40,000 a year, contribute 10 percent to your 401(k) plan, receive a 3 percent match from your employer, and earn a 6 percent, average-annualized rate of return. If you begin making these contributions when you’re twenty-two , then you would end up with over $1 million in your account by sixty-five. But if you had waited until age thirty to start saving, then you would end up with about $617,000 at sixty-five. Starting to save and invest at an early age is very important and could mean being able to retire earlier or live better in retirement with considerably more money.
Luckily, learning what you need to know to plan for a comfortable future is very simple, and you have all the tools and knowledge available to be successful. The most important principles for success are to start early, contribute consistently to the plan, and think long-term about your investment choices. If you do these three things, your chances of success greatly increase, and you will sleep well at night knowing your financial future is secure.
