Retirement planning is probably the longest-running action plan you’ll ever have in your life.
It takes decades to come to fruition with regular check-ups to ensure you’re on track. Making sure that you’re able to retire from the workforce and enjoy life afterward seems like a herculean task, but luckily there’s a go-to investment plan to help you achieve the ultimate dream – the 401(k).
As of 2016, 61% of U.S. households have some kind of tax-advantaged retirement fund with total retirement market assets worth $25.3 trillion. For the third quarter of 2017, 401(k) plans held $5.3 trillion in assets, with nearly $3.45 trillion (or 65%) of that held by mutual funds.
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Exploring the 401(k) Plan Further
The most effective retirement plan to date is the employer-sponsored 401(k) plan. It’s a creation usually attributed to a benefits consultant named Ted Benna back in 1980. After the implementation of the Revenue Act of 1978, Ted Benna interpreted this law in an innovative way, designing a retirement package for his company, The Johnson Cos., which allowed employees to put away pre-tax money to be used for retirement purposes while the company could match those contributions.
At its core, the 401(k) retirement plan is a type of employer-sponsored investment account that is able to be funded by pre-tax contributions. In other words, before taxes are deducted from your paycheck, you have the ability to invest a portion of that income right off the top. This has the added benefit of lowering your income tax liability as well.
A 401(k) also has additional benefits such as transferability to other tax-deferred retirement plans such as an Individual Retirement Account (IRA) and the option to take out loans for qualifying purposes. Hardship withdrawals are also allowed for certain events, making the 401(k) one of the most flexible retirement accounts available.
401(k) Contribution Limits
The basic employee contributions to a 401(k) are capped at $18,500 per year (as of 2018) unless you are aged 50 years or older. In that case the IRS allows for an additional $6,000 in pre-tax income to be invested in a 401(k) plan. Keep in mind that these additional amounts don’t impact the employer’s contribution, which is usually predefined as a set match up to a certain percentage of income up to a maximum level. As of 2018, the ceiling on employer contributions is $36,500 per year. That makes the total limits for 2018 contributions $55,000 for employees under 50 years of age and $61,000 with catch-up contributions applied.
The Advantages of Investing in a 401(k)
Pre-tax contributions to a 401(k) aren’t the only tax-advantaged part of the plan. Investment gains are also allowed to grow completely tax-deferred as well, so that you only have to report it when you make withdrawals. As long as you’re past the age of 59 and a half years old, you can begin making withdrawals from the account and start paying taxes at that point. This allows your money to grow unencumbered over time, maximizing profits and keep your money fully invested.
Ease of transferability makes the 401(k) highly adaptable as well. If you have a plan with a former employer, you have several options. You can choose to simply keep the old plan as it stands with the old employer, although you won’t be able to make any new contributions. This makes sense if you’re concerned about a new plan’s mutual fund options. Otherwise, rolling over the plan to a new 401(k) plan or an IRA is usually the best option, as it allows your money to stay invested and continue growing towards retirement. Finally, you can always cash out the 401(k) plan, although you’ll have to pay taxes and a penalty tax of 10% for early withdrawal too.
One of the most underutilized benefits of a 401(k) is its loan capabilities. Employees can borrow up to 50% of the plan’s balance or up to $50,000 (the lower of the two), but it must be paid back within 5 years, with the exception of borrowing to purchase a home. Interest rates on 401(k) loans are usually very low compared to other loan options as well.
Assets to Choose From
401(k) plans can come with a variety of investment options to choose from. Equity funds, bond funds and mixed funds are ubiquitous, allowing investors to customize their portfolios to suit their individual risk tolerance. Several funds come with a broad target-date fund option as well, giving investors the ability to choose something that rebalances on its own. Other companies might offer special options for certain funds, allowing investors to purchase shares at a reduced cost. Publicly traded companies often allow for the purchase of the company’s stock within the 401(k) as well.
Find out about the most important criteria for selecting a mutual fund here.
The Bottom Line
As the most popular type of retirement account, the 401(k) plays an essential role in U.S. retirement planning. As the largest single account type most people have for retirement, it’s important that you learn the details of your employer’s 401(k) plan so you can maximize its potential.
Because money is allowed to grow tax-free and your employer contributes funds on top of that, real gains on this type of account can far exceed any other type of product. For instance, even if the market performs flat for the year and you invested $1,200, your employer can match that amount and you’d essentially have a 100% profit regardless. When contributing, you’ll want to carefully look over all the fund options the plan offers and keep an eye on how it’s growing. Finally, a regular rebalance every 6 months is a good way to keep your portfolio healthy and strong.
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