Why you need a good 401k Plan - Happy Candles

Why you need a good 401k Plan

by happyc | January 22, 2019

If you have a 401k plan available at work, this qualified retirement plan is one of your most valuable retirement planning opportunities. From the tax-deferred growth and up-front tax deduction to the benefits from automatic savings, your 401k plan is a critical component in your quest to achieve financial independence. Considerations for a 401k plan include:

 

Why Enroll in a 401k Plan

Your 401k plan enables you to automatically take advantage of tax-deferred growth. With gradual elimination of most defined-benefit pension plans and great uncertainty around Social Security, saving for retirement on your own is increasingly critical.

 

How to Enroll in a 401k Plan

Although some companies automatically enroll employees in their 401k plans, you may need to complete a simple form to participate in your plan. You’ll determine how much to save and select your investment options. Don’t worry! The amount you save, the way you invest, and even your continued participation in the 401k plan are all decisions you can change at any time.

 

A 401k Plan is Employment-Related

You can only participate in a 401k plan if your employer allows you to do so. Your employer must both offer a plan and you must be eligible to participate. Therefore, you cannot set up a 401k plan on your own. (However, if you work, you can establish an Individual Retirement Account (IRA) privately. If you’re self-employed, you’ll have other retirement planning options as well.)  The key is to avoid missing out on this important opportunity to save for retirement. Missing out on the tax-advantages of 401k plans and matching contributions are some of the biggest mistakes people make when starting a new job.

 

How Much Can You Contribute to a 401k Plan?

The amount you save in your 401k plan is often called your contribution percentage. If your gross pay is $3,000 and you’d like to put $300 of each paycheck into your 401k plan, you’ll need to indicate a contribution percentage of 10%, since 10% of $3,000 is $300.

 

401k Plan Contribution Limits

For the year 2017, the most you can contribute to a 401k is $18,000. If you are 50 or over, you may contribute a total of $24,000. Your employer may further limit the amount you are eligible to contribute. Note that IRA contribution limits are completely separate.

 

401k Plan Contribution Deadline

Unlike an IRA, there are no deadlines for contributions. However, the sooner you enroll, the sooner you can begin tax-deferred saving for your retirement.

 

401k Plan Tax Deductions

Every regular 401k contribution immediately reduces your taxable income. For example, an individual in the 25% tax bracket who makes a $100 contribution to her 401k plan will immediately save $25 in taxes. (25% x $100). Although her 401k balance increases by the full amount of her $100 401k contribution, her paycheck only decreases by $75! Unfortunately, a 401k contribution does not reduce the amount you must pay in FICA and Medicare taxes.

 

How 401k Plans Offer Tax-Deferred Growth

Since the money in your 401k plan grows tax-deferred, you do not pay taxes on the earnings in the account. In fact, you do not even report the income to the IRS. It is not until you take your money out of the 401k plan, ideally during retirement, that you owe taxes.

 

Investing Your 401k Money

Investing your 401k money is critical to its long-term growth. Your investing strategy should change over time. The younger you are, the more aggressive your asset allocation should be, meaning increased ownership of stocks. As you near or enter retirement, your 401k balance should begin to reflect the reality that distributions are not too far away, and you should have a smaller share of your retirement money invested in stocks.

 

No Income Limitations to Participate in a 401k Plan

Unlike many other tax deductions and credits, eligibility to contribute to a 401k plan is not restricted by any maximum level of income.

 

Employer Matching 401k Programs

Many employers provide matching contributions to their employees’ 401k plans. In an employer matching program, the company puts money in the 401k plan of each individual who also contributes to their 401k plan. If you choose not to participate in your 401k plan, you typically forfeit this matching contribution. That’s why not participating in a 401k plan up the level an employer matches is often called turning down free money.

 

Increasing your 401k contributions over time

Many 401k plans offer automatic rate escalation features that allow you to gradually increase contributions. With contribution rate escalation you maintain control the amount and timing of future contribution increases. Some companies even choose to automatically enroll new hires into retirement plans with the ability to opt-out of contribution rate escalation. This “set it and forget it” approach can provide a significant boost to your overall retirement savings.

 

Required Distributions from 401k Plans

In most cases, you must begin to take money out of your 401k plan starting with the year after you reach 70 1/2. The required minimum distribution amount is determined by the Internal Revenue Service and is based on your life expectancy.