Sooner or later; young professionals have to decide whether or not to invest in a 401(k). Employees are either briefed about it at the time of induction or the 401(k) may have found a teeny-weeny mention in their job welcome kits. Any which way, this retirement option may have long been drained out of your brain.
And even if you remembered; you probably didn’t like the idea of parting with a portion of your income today and you also didn’t have much faith in the promises of seeing a bigger return on your investment many years from now.
What you decide is totally upto you but before you do that, let’s play wise and look at some of the basics of 401(k):
1. So what is a 401(k)?
In a lay-man’s term, a 401(k) is an arrangement wherein an employee, i.e. you, contribute money to an account that usually is pre-tax. You can choose from a varied range of options to invest your money on and your company will contribute an agreed amount of money to your plan as well.
2. Matching. So what is Matching?
Matching basically is Money God’s gift to your retirement. A lot of companies will match your contribution to a 401(k) with a certain percentage of payment from their pockets. For instance; let’s assume they’ve agreed to match 100 percent of your contributions, up to 3 percent of your income.
And your income happens to be $100,000 in a year (trust me, that’s a good amount of money) so you contribute $3,000, i.e. 3 percent of your income. Your employer will then match that with another $3,000 from his pocket, i.e. 100 percent of your investment. In about a year’s time, barring investment gains, your 401(k) savings would jump from $3,000 to $6,000. Thank God… Money God!!
3. We now move on to what is called – Vesting
Vesting, much like the word investing, is where a company will try to protect its investment on you by setting up a plan in which you are not—immediately—entitled to the entire amount the company has matched towards your 401(k). You will be required to wait a few years before you’re fully vested which subsequently entitles you to the full rights over your employer’s contributions towards your retirement account. Different companies have different policies on Vesting.
In order to understand, let us take the help of the following example:
You are required to work with your company for four years before you’re fully vested. This means that if you quit before that, you will not be entitled to keep all the money they’ve contributed. You are, of course, entitled to your portion of the contribution right from the word go. But if you quit after–say, two years–you might just be able to keep only 50 percent of your company’s contributions. Employers normally do this to encourage longevity of your employment with them and quite fairly so.
4. So What Happens to My 401(k) Contributions If I Leave My Job?
You keep ’em all. There are a few ways you could do that. Option #1 is to cash it out, but you’re gonna be bombarded with taxes here along with a 10 percent penalty for taking the money out early. Option #2 is to leave the money where it is (provided your employer has a kind heart) and allow it to continue to grow. Option #3 is to roll it over into your new company’s 401(k) or into an IRA. Come what may; that money is yours.
5. Do I Have to Pay Taxes on My 401(k)?
Many years from now, when your 401(k) tree is fully grown and you can pluck money out of it; you will have to pay the standard income tax on it. But you don’t have to pay taxes on a real-time basis, i.e. if your income is $100,000 and you put $10,000 into your 401(k) this year, your taxable income for this financial year becomes $90,000 and not $100,000.
6. Will there be a Limit on How Much I Can Contribute?
Yes. As of 2013, the limit is $17,500 in a given year. This; however, excludes your employer’s contributions. The combined contribution limit for 2013 is $51,000 and the reason these limits are in place is because these contributions are tax-deferred.
7. What’s the point in starting to invest now?
Well; the sooner you sow, the more you reap; courtesy the compounding growth. With compounding growth, you’ll earn profits on both the money you contribute as well as on the returns from your original investments over the course of time. So 401(k) is like your Money Tree bearing fruits…that’ll in turn grow up to be separate Money Trees bearing its own set of fruits…and the process goes on. Time is of the essence here; the sooner you start, the more Money Trees you’re gonna have in your back-yard.
Hopefully this will add more feathers to your Financial Cap.