If retirement is your destination, your 401(k) is a primary vehicle to get there.
Despite its rather technical name, a 401(k) is simply an employer-sponsored retirement plan for private companies. Whereas consumers can open an Individual Retirement Account (IRA) at any time, a 401(k) is offered exclusively by employers.
Roughly 60% of Americans have access to an employer-sponsored plan (though only 32% are actively investing in one).
With a 401(k), employees can automatically contribute a portion of their pre-tax dollars and invest it in the stock market. Investment gains grow tax-free, and in most cases, are best left alone until retirement (as we’ll discuss below).
The returns can be remarkable, especially over an extended period of time.
In fact, according to recent studies, the average 401(k) return in 2020 was a staggering 15.1%. Though 2020 was an outlier, the previous five years have averaged an excellent 11%.
Even with more conservative gains, the power of a 401(k) remains undeniable. For example, if you put $100 a month into your 401(k) for 40 years (at an average annual return of 7%), you will earn roughly $240,000.
That’s only the beginning of the benefits. Here are three ways to make the most of your 401(k):
1. Take Advantage of Your Employer’s Matching Program
While few things in life are free, your employer’s 401(k) match gets as close to “free money” as possible.
When an employer offers a matching program, they agree to contribute a specific amount of money to your 401(k) based on your own contributions.
While the average company match is currently 4.7% of employee salaries, the specifics vary widely.
In some cases, employers will give dollar-for-dollar matches up to 3% of the employee’s pay. Other companies may offer a $0.50 employer match of up to 6% (where employees provide 50 cents for every dollar the employee contributes to their account).
However, your employer structures their matching program, be sure to capitalize on it.
While a 401(k) has tremendous value on its own, an employer match can exponentially increase its power.
For the sake of example, let’s say a 30-year-old employee makes $40,000 a year and contributes $100 a month to her 401(k). She does this until the age of 65, when she will have contributed a total of $42,000 (without employer match).
Now, let’s rewind the clock.
This time, the same employee contributes $100 a month and takes advantage of her employee’s dollar-for-dollar match of up to 3% of her salary.
By the age of 65, she will have accumulated $84,000 and literally doubled her investment.
Want to see how your savings will grow with your 401(k) — and how your company’s match can rapidly increase your balance? Click here to use this free 401(k) calculator.
2. Aim to Maximize Your Tax Break
Here’s another reason why 401(k) plans are so powerful: they can help you defer paying income tax each year.
For the current tax season, you can contribute up to $19,500 across your 401(k) plans (if you have more than one).
If you’re age 50 or older, you can make an additional “catch-up contribution” of $6,500, thereby increasing your total limit to $26,000.
For example, let’s say you made $65,000 last year and maxed out your contribution by putting $19,500 into your 401(k). Now, instead of paying taxes on your initial salary of $65,000, you’d only owe taxes on $45,500.
That’s a huge difference.
Plus, while you’re shielding yourself from the burden of taxation, the $19,500 you invested will be busy growing at rapid rates.
Obviously, maxing out contributions is easier said than done, and there are other financial goals to worry about (like growing your emergency fund and paying down debt).
Aim to contribute what you can, and start growing your money as soon as possible.
According to Marguerita Cheng, CEO of Blue Ocean Global Wealth, “The sooner you can increase your contributions, the sooner you can have your money working for you.”
3. Be Patient (And Don’t Cash Out Early)
As your 401(k) grows, it can become increasingly tempting to cash out before the age of retirement.
Technically speaking, you can begin taking withdrawals without paying a penalty at the age of 59 ½. Withdraw anytime before then, and you’ll be paying a price.
Unfortunately, well over half of all Americans have taken an early withdrawal from their retirement accounts (especially since the height of the COVID-19 pandemic). Worse yet, a majority of millennials have done the same — despite the relative infancy of their accounts.
Tapping your 401(k) can have devastating consequences. On the one hand, you’ll be subject to income tax plus an additional 10% tax penalty levied by the IRS.
Depending on your tax bracket, an early withdrawal could eat up to 50% of your money!
Those are merely the immediate consequences. When you cash out early, you also interrupt the compound interest that generates the bulk of your retirement savings.
According to Greg McBride, Chief Financial Analyst at Bankrate, “Withdrawing money early from a retirement account costs you now, and it really costs you later. Every dollar withdrawn today could be $10, $15, or $20 by the time you retire, so an early withdrawal robs your future nest egg of a significant sum.”
While it’s tempting to borrow from your 401(k), make no mistake: cashing out before the age of retirement deprives your future self of financial security.
Note: There are a few special cases where the Internal Revenue Service (IRS) will permit early withdrawals without penalty. For example, if you lose your job and are between the ages of 55 and 59 1/2, the IRS will allow you to withdraw without an extra cost.
Click here to view the IRS’s full list of penalty-free withdrawals.
Ultimately, a 401(k) is a wonderful tool to invest in yourself and your future.
Though it takes discipline to grow (and even more discipline to leave it alone!), your 401(k) helps lay the foundation for a secure and fruitful retirement.
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