How to make the most of your 401(k) plan is a question that employees often find themselves puzzled with. With pensions few and far between, new employers are offering 401(k) retirement plans to their employees but many blue-collar workers have a difficult time getting the maximum benefit from these plans. By following some helpful points even the newest of investors should have a comfortable grasp of what to do with their 401(k) plan to help generate a nest egg to retire with.
The first thing an employee can do to maximize their 401(k) is to increase their contribution rate.
Typically when a 401(k) is started an employee has a default rate of 3-4% of their income automatically contributing to the account. While 3-4% may seem like a lot, for most this is not an efficient amount to capitalize on the 401(k) accounts benefits. New employees are urged to raise this amount every year by at least 1% until they reach a 15-20% contribution rate. Many accounts have the benefit of an employer match as high as 6-7% so if an employee does not at least contribute enough to receive the full match they are essentially throwing away money. Some companies will offer an employee a 50 cent match for every dollar contributed and others will offer a full dollar-for-dollar match. Be sure to make the maximum contribution to capture the full value of your employer’s match, one of the best features associated with many 401(k).
A Roth 401(k) works the same way as a Roth IRA account and offers the benefit of tax-free withdrawals because the money deposited has already been taxed. It is recommended to open this account alongside a traditional 401(k) and deposit a percentage of funds there to provide you with some flexibility going forward. This type of account will work best for employees who will be in a higher tax bracket in retirement because they have the opportunity to pay tax on the earnings now at the start of a career.
Other than an employer match, the leading benefit of a 401(k) is the plan’s tax breaks. A traditional 401(k) plan allows an employee to defer paying income tax on the earnings contributed to the account until the funds are withdrawn. This means the money gets to grow in the chosen investments tax-free and will be compounded at a much greater rate since you’re saving whatever taxes would be paid on a conventional investment. The tax-free contributions offer such an advantage that there is actually a limit to the annual contribution. As of 2016, you can contribute a maximum of $18,000 and if you are over 50 years old, you are allowed to make what’s known as a catch-up contribution of $6,000 for a total of $24,000.
When an investor withdraws from a 401(k) before age 59 ½ they will pay a 10% early withdrawal penalty as well as any tax on the funds withdrawn. This typically happens when an employee leaves a company and needs the money in the interim while searching for a new job. As tempting as it may be to withdraw 401(k) funds, remember this money was put away for retirement, and making sure it stays there will have a large impact later in one’s career.