Whether you’ve just started your first corporate gig, or if you’ve just been thinking about securing your future, you’ve probably heard the term “401(k)” thrown around a lot, and how you should open one that’s being offered through your workplace. So what is a 401(k) exactly?
401(k) in a Nutshell
Having the (k) in its name fools people into thinking it’s a very complex financial product or plan to grasp. But plain and simple, 401(k) plans are retirement plans set up and sponsored by your employer. For self-employed professionals like freelance writers or home-based accountants, you can open an individual 401(k) plan.
How it works is you set aside a certain portion of cash per month that’s automatically deducted from your paycheck. The amount to be set aside depends on how much you’ve elected to allocate for the retirement plan. You have the choice of investing in a broad range of assets, such as stocks and bonds, which can either be chosen from a prepared group of assets or selected manually by you.
Benefits of Owning a 401(k)
For starters, the monthly investments put into your 401(k) can compound into a large sum of cash, given that you maximize your monthly contributions and do not withdraw anything from the account prematurely.
Through a 401(k) account, your employer may elect to match every dollar of your contributions, which is basically free money. Most employers have a 401(k) match program, and they will usually match up to $4, if not dollar-for-dollar.
Just because you put your money in a retirement plan, it doesn’t mean you completely lock up the cash until you retire. It’s highly advised against, but you can borrow money from the account for particular purposes, such as purchasing a home, sending your kid to college, or paying for unforeseen medical expenses.
One downside to borrowing funds from your 401(k) is that you are usually charged interest that must be paid back. But as long as you work for the employer sponsoring your 401(k) plan that you used to secure the loan, you will not be liable for any income taxes.
Building Your 401(k)
Choosing the assets you wish to invest in through your 401(k) can be intimidating, especially for those who have close to zero experience and knowledge with regards to financial markets. Fortunately, your employer will already construct a list of asset choices with the help of an investment broker. The downside to this is that you get stuck with whatever list they come up with.
As a general rule of thumb, you should build a portfolio that aligns with your risk profile. There are basically five types of funds you will be choosing from – stocks, target-date, blended-fund, bonds/managed, and money market. A thorough analysis of each group of assets should give you a better grasp of which ones to choose.
The next thing you’ll have to figure out is the monthly contributions you want to set aside for your 401(k). It all comes down to your monthly expenses, for instance, you obviously want to make sure you have sufficient income to pay the bills and buy your family’s basic needs. Other factors that merit consideration include employer dollar matching and maximum allowed contributions.
Investing can be somewhat tedious, yet is something that’s crucial for your future self. Make use of all the resources given to you to make solid decisions, and navigate your first 401(k) retirement plan effectively, and with confidence.