401(k) Accounts
A 401(k) is a type of retirement investment account sponsored by employers. If you were to invest the maximum amount of contributions allowed to your 401(k) every year for the next 25 years, you will save over $1.5 million for retirement! In that time, you would have contributed $575,000 while earning almost $1 million in interest. That's what compound interest can do for you. Use the 401(k) calculator below to see how you can take advantage of 401(k)s and compound interest to save up comfortably for retirement.
What is a 401(k)?
401(k)s are employer-sponsored retirement investment accounts where employees can invest a portion of their paychecks before taxes are taken out. There are many benefits to 401(k)s that make these accounts exceptional tools for retirement savings. Many employers offer a 401(k) match, essentially giving you free money just for contributing to a 401(k). Additionally, there are tax benefits to 401(k)s and there are even Roth 401(k) accounts where your investments grow tax free.
Here are the typical steps for making 401(k) contributions and withdrawals:
- Contributions: You will chose a percentage of your pre-tax salary to add, or contribute, to your 401(k) account. In 2024, the 401(k) contribution limit is $23,000, not including any 401(K) employer match. If you contribute to a Roth 401(k), money is added to the 401(k) account after taxes are taken out.
- 401(k) Match: Employers often offer to match a portion of their employee’s contributions, up to a certain percentage of their salary. This means that if you contribute to a 401(k), they will add extra money to your account on top of your contributions. This is a form of extra compensation for employees, and it is essentially “free” money added to your retirement savings!
- Investment Options: Each employer chooses a 401(k) plan that includes a set of funds that employees can choose from. These funds may be stocks, bonds, mutual funds, or exchange-traded funds (ETFs). By investing money in a 401(k) during your working years, you are setting yourself up to experience tremendous growth and compound interest on your retirement investments!
- Tax Benefits: Contributions to a traditional 401(k) are made with pre-tax dollars, which reduces your taxable income for the year. Additionally, investment gains within the 401(k) account are tax-deferred, meaning they are not taxed until you make an eligible 401(k) withdrawal in retirement. On the other hand, if you have a Roth 401(k), the money from your paycheck is taxed and then added to your 401(k) account. In this scenario, your money grows tax-free and there are no additional taxes to pay on your contributions or gains when you make eligible 401(k) withdrawals.
- Withdrawals and Penalties: Typically, 401(k) withdrawals are not allowed until you are 59.5 years old. Any withdrawals made earlier than that may incur taxes and early withdrawal penalties, except in certain circumstances such as a disability or financial hardship.
How to open a 401(k)
Let’s open a 401(k) and get your money working for you! If you are eligible, you can open your account and choose your funds in a matter of minutes. Here’s how to get started:
- Ask your employer if they have a 401(k) plan and if you are eligible to participate. Most full-time employees are eligible, but some part-time employees or those in specific job categories may not be.
- Open your account and set up automatic contributions. Enrolling in your employer’s 401(k) plan often involves filling out some paperwork. This may include providing details about how much you want to contribute from each paycheck. Try to contribute as much as you can so you can watch your investments grow over time and earn that compound interest! The 401(k) employer match is often directly proportional to your contributions so try to get as much of that free money as you can. Common advice is also to increase your contribution by 1% each year, or whenever you receive a raise.
- Choose which funds to invest in. The most commonly recommended investment options in 401(k) plans are target date funds, which are funds made up of stocks and bonds. Choose the target date fund that corresponds to the year you expect to retire in. If you have decades until retirement, the fund will be comprised of mostly stocks and very few bonds. As you get closer to retirement age, the fund will move to a lower amount of stocks and a higher amount of bonds, automatically managing the risk for you! Another thing to keep in mind when choosing funds is to keep the expense ratio low. The higher the expense ratio, the less your money will grow.
- Watch your money grow! 401(k)s offer an incredible and tax-advantaged opportunity to build a nest egg for your future. Just choose your fund(s) and follow the "set it and forget it" strategy. If/when you leave your employer, you may have the option to keep your account in your now previous employer's plan, roll your current 401(k) into the 401(k) account you will set up at your next company, or do a 401(k) to IRA rollover. Whichever method you choose, ensure your money stays invested in the market for the long haul.