What is a 401k?
A 401k is a retirement account that is offered by your employer. Like all retirement accounts, it offers tax advantages to those that choose to contribute to them. It’s tax advantages differ from other retirement accounts, but a 401k would be the first retirement account that I would contribute to under the correct circumstances. We are going to get fairly deep into the 401k account in this post so hang on!
When and How Much Should I Contribute to a 401k?
The ONLY circumstance that you should contribute to a 401k is when your employer offers to match your contributions. Most employers offer a 401k plan, but not all offer a match. An employer match is basically free money. However, your employer will establish a limit to the amount of free money that they will give you. The limit will likely be some percentage of your salary. For instance, your employer may offer to match your contributions dollar for dollar up to 3% of your annual salary. So if you make $100,000 a year and contribute 3%, which is $3,000, they will contribute another $3,000. However, they will not match any contributions over that 3%.
Once you have reached the annual limit that they have set, DO NOT contribute any more money to your 401k. There are retirement accounts with better tax advantages that you should store your money. The main advantage to a 401k with an employer match is that you can receive an immediate return up 100%. However, if the match is not offered, do not contribute to your 401k.
401k’s Tax Advantage
A 401k allows you to invest money that you’ve earned before it has been taxed. When you receive a paycheck from your employee, the money that is directly deposited into your account has already had been taxed. This is why someone with a $60,000 salary doesn’t actually make $5,000 every month ($60,000 / 12 months = $5,000 per month). But when you elect to contribute to your 401k, your contribution amount goes into your retirement account before your income is taxed. So if you make $5,000 a month before taxes and elect to contribute $500 a month to your 401k, $500 will go into your 401k and only the remaining $4,500 will be taxed before you receive it. However, you will end up paying taxes on the money in your 401k when you to take money out.
How is a 401k different than an IRA?
The main difference between a 401k and a Roth or Traditional IRA is that you are contributing after-tax dollars into an IRA. However, you do not pay taxes on your money when you take money out of an IRA. In simple terms, you pay taxes on the front-end of an IRA and on the back-end of a 401k. To see the differences between a Roth and Traditional IRA, check out my post “Traditional Vs. Roth IRA.” However, I do believe that the tax advantages of an IRA are better than a 401k. This is why you should not contribute to your 401k if your employer doesn’t offer a match. Instead, contribute your money into an IRA.
A 401k is another type of retirement account with tax advantages. If your employer offers a match, TAKE ADVANTAGE OF IT. But if they don’t offer one, place your money in an IRA. When you do contribute to a 401k, only contribute up to the amount that your employer will match, not a penny more. The tax benefits of a 401k come on the front-end, whereas the benefits come on the back-end of an IRA account. Later on, we will discuss what to do with the money you have in a 401k if you separate from your employer. Stay tuned as we discuss how to plan for retirement. Thanks for reading!