Understanding the basics of a 401(K)-retirement savings plan
As we move along in our jobs, careers, and hustles it is so important you plan for the future, even if it seems so far away. Don’t be like your Tia Lupe, hiding money under the mattress as a savings plan, lol. Planning ahead in terms of retirement is important, as the cost of living is increasing and there is no guarantee that Social Security will be a source of income in the future as it is was for our abuelitos, que triste ☹.
With a first full-time offer you may be overwhelmed by the 401k plans offered by your employer. You probably whispered to yourself 401Que? Don’t worry girl we got you. To break it down into simple terms a 401k Plan is basically a savings account dedicated solely to having funds in retirement. The big idea of 401k Plans is simple but there are other factors in play as well. Amigx, let me break it down for you….
Que Es Un 401(k)?
A 401K is a savings and investing plan ONLY offered by employers, but not ALL employers offer it, sadly (keep in mind different employers offering different retirement/investment plans so do your homework) that gives employees a tax break on money they set aside for retirement. These plans were created to help you save for the future in an easy way because contributions are automatically withdrawn from your paycheck and invested in funds of your choosing.
401Que? Here are a few fast facts, that NerdWallet put together:
- The catchy name comes from the section of the tax code — specifically subsection 401(k) — that established this type of plan.
- You as the employee contribute money to this individual account by signing up for automatic deductions from your paycheck.
- Depending on the type of plan you have, the tax break comes either when you contribute money or when you withdraw it in retirement.
- A 401(k) is a tax-favored retirement savings account offered by employers, meaning before you get taxed on that paycheck (your gross income) you get to contribute money into this account.
- In 2020 you can contribute up to $19,500 a year
- You can contribute to both a 401(k) and an IRA in one year (check out our IRA post to break it all down)
- The biggest drawbacks of a 401(k) are plan fees and limited investment options
- If you leave your job, you can roll over 401(k) funds into an IRA or into your new employers 401K plan
Types of 401(k) plans:
There are two common types of 401k Plans, a Traditional 401k and a Roth 401K Plan.
- In a Traditional 401k Plan the money that is put into the account does not get taxed right away. What this means if you earn $50,000 and you put $5,000 (10%) into your 401k Plan then your taxable income will only be $45,000. Thus, paying less in income tax for the year. In a Traditional 401k Plan the money will be taxed as income per year. In this plan you may pay less in taxes because as a retiree you have less income.
- On the other hand, there is the Roth 401(k) plan, think of this as the unicorn of retirement plans. A Roth 401(k) gets taxed right away. With this option you owe nothing to the IRS on the money as it grows. Remember we mentioned depending on the type of 401(k) plan, you get a tax break either when you contribute or when you withdraw money in retirement? Well, the IRS can charge you income taxes only once. With a Roth 401(k), you’ve already paid your due because your contributions were made with post-tax dollars. So when you withdraw money in retirement, you and Tio Samuel are already settled up.
To access the money in the 401k Plan you can only do so upon the following criteria
- Upon retirement, death, disability, or separation from the employer
- Employee reached the age of 59.5
- If the plan permits hardships withdrawals and the employee experiences such hardships
- Employer’s retirement plan would have this outlined in their plan
Note* – it is highly suggested, and we highly encourage you to NEVER touch the money in this account until you hit retirement, unless it is an absolute dire emergency and you tried all other options. DO NOT TOUCH THIS ACCOUNT OR TAKE MONEY OUT
“If this is the point at which you dozed off during employee HR orientation, you missed the best part — don’t worry girl we’ll repeat it The tax break comes either when you contribute money or when you withdraw it in retirement, and if your employer matches that is FREE money”
Cómo Trabaja un 401(k)
When you accept a job offer that offers a retirement plan they usually give you a default set of investments. Take some time to go through it and research the different stocks presented. Adjust it to what suits your living situation and work timeline. Be risky with your portfolio if you are far away from retirement. As you go through your career/life you can change the investments so they are less risky.
If it is too overwhelming look for a Target Retirement Fund. This fund includes different types of investments such as stocks, bonds, real estate, international stocks, etc. This is a great option if you are unsure of how to diversify your 401k Plan. When selecting the target year for the fund choose the year where you are closer to 70 years old. For example if you were born 1997, your Target Retirement Fund closure year would be 2066 so you will be able to access it in 2067 when you retire at 70.
Employer Matching Funds
OMG, this is one of the best perks and honestly can be a good reason you take a job offer if you are debating over a few. Also, if the salary is not what you expected but they offer to match definitely something you should absolutely take into consideration, I know the money is not an immediate satisfaction, but mija you will be so glad you did in the long run.
A matching fund is when the employer offers to match the employee’s contribution to the company’s 401k Plan. Think of it as free money, yes you heard me GRATIS amigx. Pretax contributions make saving a little less painful. Contributions to a traditional 401(k) plan are taken out of your paycheck before the IRS takes its cut, which supersizes each dollar you save. Let’s just say Tio Samuel normally takes 20 cents of every dollar you earn to cover taxes, jaja. A common match fund is where the employer will match between 50%-100% of your contribution to 10% of your income. Every employer will have different policies regarding their match funds.
Por ejemplo, you earn $50,000 a year and you put 10% into the company’s 401k Plan, that is $5,000 into retirement a year. The company will then match that amount either $2,500 (50%) or $5,000 (100%) in addition to the $5,000 you already put in. If your employer offers this plan take advantage of it as it increases how much money goes into your retirement plan without it coming out your pocket.
So you’re thinking to yourself, pero how much should I be putting away towards retirement?
My recommendation is the most you possibly can, between 10%-20%, don’t go lower than 10% trust me I made this mistake and I am totally paying for it now. Remember this is before taxes, so you really never even see the money because you only see your net income, or what you make after taxes. But the younger you are, the more opportunity to take advantage of putting more away. As you get older even though your salary make increase, so do your expenses so it gets harder and harder to put more money into a savings account.
If you accept your employer’s match plan, in 2020 then you are maxed out at $57,000 below the age of 49 and at $63,500 if over the age of 50.
Don’t Fall To Withdraw
It is expected to change employers as you move through your career. When moving onto the next stage you might get offered to take cash for your retirement plan. As tempting as it might be do not take the cash! You will have to pay taxes on the cash as well as the penalty fee associated with accessing the money before the age of 59.5. Keep your retirement plan intact as the money in it will continue to grow. So although you are legally allowed to access the money because you left your employer, it will be better in the long run to keep the plan active than closing it and getting cash.
Whew, we know that was a lot of info amiga, we hope we did a better job then the HR orientation meeting, jaja. But don’t feel intimidated by the idea of 401k and retirement plans. Take some time after your onboarding process with a new job to look over the retirement plans and their policies. Take advantage of what they offer such as matching funds even if it is for only a short-period of time. Make the most of your 401k Plans by understanding the basics and by moving forward to look-up what you don’t understand, regardless of how you go about it just be sure you choose one and you open it up, DO NOT skip this or put it off or think you don’t need it. Believe me the earlier you begin the better and the more money you will have going into retirement or possibly retire early, like in your 40’s if you are really smart with your savings.