What is the 401 (K) Plan?
A 401k is a savings plan through which employees can save a fraction of their salaries to go towards their retirement. The savings are in the form of deductions from an employee’s salary, and their taxation is referred to. Also, an employer is allowed to contribute to the scheme as guided by the provisions of the plan.
How 401 (K) Plans Work
According to the law, the 401 (K) plan is supposed to be managed by the employer. This means that the employer will have a say in how much you can contribute to the plan and the amount of money they will contribute themselves. In addition, the employer will have a say on which investment firm will run the savings schemes on their behalf and whether or not employees will be eligible for loans and emergency withdrawals under the plan.
Employees are not obligated to contribute to the 401 (K) plan, but if they choose to do so, they must specify how much they will contribute. The savings aren’t taxed at source but are due for income tax cuts during withdrawals. The funds mature for withdrawal once an employee attains the age of 59 and a half years old. However, you can withdraw them before you attain that age, although the funds will be liable for a penalty of 10% in that instance unless you can make a case for hardship or emergency.
The money isn’t deposited in a bank and left to lay idle but is usually invested. Since the plan is the employees’ earnings, they have the ultimate decision-making role in how they would like their money to be invested.
Steps to investing in 401 (K) plan
1. Know what you’re getting into
401(K) plans are funds deducted from years of work and sacrifice. This means that you should think hard about how you would like your money to be invested. The wrong decision can either result in a meager profit or cost you a substantial amount of money. Typically, employees select investment companies such as Fidelity, Schwab, etc. You should therefore be sure to do your due diligence check before entrusting these firms with your money. Know what you stand to gain, what you could potentially lose, and the risks you are exposed to.
2. Decide on how much you want to contribute
Ideally, your contributions to a 401 (K) savings plan should not be less than 10% of your pay. However, you have the freedom to decide how much you would like to contribute. Ensure that whatever amount you contribute will enable you to live a decent life after retirement without compromising your ability to meet your current needs. It is advisable to start saving as soon as you can lay your hands on a 401 (K) plan to maximize your savings, especially considering that your employer will be contributing to your retirement kitty too.
3. Evaluate how much you are willing to risk
As highlighted above, your 401 (K) savings will be invested in a segment of the economy, with an aim of earning you interest. While you are better off having your money work for you, there are no guarantees that your investment will earn you good returns. Typically, an investment fund will put your money in bonds, stock, index funds, or any other asset that promises good returns.
This, therefore, means that your savings will not be immune to shocks and downturns of the economy. Therefore, you should evaluate the type of investment you want to commit your money to before putting your money on the line. Consult widely and assess the risk levels of each investment option available to you.
Weigh the pros and cons of each investment venture so that you fully understand what you are getting into. For example, bonds are a “safer” bet, but they will hardly earn you great returns. On the other hand, stocks are quite risky but could give you above-normal returns. You should also compare the investment record of the financial firm managing your plan savings to gauge if they know their trade.
4. Pick your investments
As highlighted above, investing is not without its risks. With that in mind, investment firms typically will have a choice to choose among risky high-profit investments like stock and low risk, low-profit investments. Pick the right mix to balance between risk and profit. Otherwise, you may not get the best out of your plan.
5. Increase your contributions over time
Increasingly, you will come across great investment ideas or opportunities that may require you to reassess your earlier choices. This, therefore, makes a strong case as to why you should strategically increase your contributions to the plan. That will enable you to diversify your investments while also increasing your profit margins.
The other way to look at it is that your salary will almost certainly rise over the years. It is therefore prudent for you to raise your contributions to the plan as a way of strengthening your standing.
Advantages of 401 (K) plans
1. Tax relief
This is among the most attractive aspects of 401 (K) plans. First, employees’ savings aren’t counted as income. This means that they stand a chance to qualify for lower taxes. Secondly, you will not pay a dime on your 401 (K) plan savings until such a time that you withdraw them. You are, therefore able to focus on building your earnings without worrying about fluctuations in tax regimes that are often ushered in by different administrations.
2. Protection from creditors
According to the Security Act, 1974, 401 (K) savings are insulated from claims from creditors. This, therefore, ensures the protection of your savings from potential cuts emanating from creditors’ claims. This should therefore give you peace of mind knowing that your money is safe from external interference.
3. 401 (K) Flexibility
401 (K) plans can be transferred or rolled over when you change jobs. This means that you can still choose to retain your money under the previous investment framework, even after moving to a new employer. This ensures continuity and gives employees peace of mind when they want to take up new jobs or when they land better opportunities.
401 (K) plans provide employees with excellent opportunities to not only save a portion of their earnings but also put those savings to good investment schemes. However, it is invariably important to do due diligence before committing your money to a particular investment scheme. It is also very important that you understand the risks involved. Also, you should start contributing to the plan at the earliest opportunity.