Benefits of Having a 401k
While 401k plans may not be on your mind when you are in your 20s, you should start saving for retirement as soon as possible. Both you and your employer can make 401k contributions to help build a nest egg when you are no longer working.
Although there are many laws and requirements surrounding retirement accounts, contributing to a steady amount will greatly benefit you later. Find out more about the specific benefits of having a 401k below.
What are 401k plans?
Whether a Fidelity 401k account or through another financial investment management company, a 401k is a savings plan that is available at retirement. However, a 401k is not just a savings account.
Management companies invest the funds in 401k plans into stocks, bonds, money markets and mutual funds. These investments are like seeds to help your money grow, however, there some investments may be riskier than others.
Types of investments include the following:
- Stocks – Publicly traded companies divide ownership into “shares” or stocks. When the value of the company rises, so does the value of the stock.
- Bonds – These investments are loans to companies that will be paid back plus interest.
- Money markets – These are saving accounts that typically offer higher rates of interest than traditional savings accounts.
- Mutual funds – These investments are a culmination of many stocks, sometimes referred to as a portfolio, and are professionally managed.
401k plans get their name from the Internal Revenue Code. Since 401k contributions are from income not yet taxed, you will need to pay the deferred taxes when you withdraw.
Why You Should Make 401k Contributions
Saving for your retirement should begin with your first paycheck, as it can take decades to put away enough for the years when you are not earning an income. Rather than simply tucking money away into a savings account, making 401k contributions can help you save more, faster.
It is recommended that you save between 10 to 15 percent of your earnings. Below are examples of 401k contributions:
- Scenario A – A worker who earns $40,000 annually (and has a salary increase of 3 percent a year) contributes 10 percent of his income from 21 years of age until 67. The employee will have made $397,586 in 401k contributions during those 46 years of saving. With a rate of return of 7 percent, the worker should have $1,927,468 in his account by retirement.
- Scenario B – If the same worker above has an employer with 401k plan limits that matches 50 percent of the worker’s contributions up to 6 percent of his annual salary, then the additional $119,276 in employer-match funds will increase the balance to $2,505,710.
- Scenario C – If the worker makes contributions under the same conditions above but doesn’t start until 31 years of age, then he will only have $1,149,926 after investing for 36 years.
Funds invested well in 401k plans are better than those simply saved since they will grow. Employer-matched contributions to your 401k account are, basically, free money you can use when you have retired.
Many employers match their employees’ contributions, however, these funds may be vested. This means that employees will need to continue to work for the company for a certain period to retain employer-matched contributions.
Keep in mind, any funds you personally contribute to your Fidelity 401k account are yours and you will not lose the stocks you’re already invested in if you leave your company.
401k Benefits and Rules
If you have the means, then you may be tempted to throw as much money into your retirement account as possible. This is especially true if you are making 401k contributions later in your life.
However, the federal government puts 401k plan limits on annual contributions, which can change from year to year. As of 2020, tax-deferred 401k plan limits are set at $19,500 annually or $26,000 if you are older than 50 years of age.
What Happens When You Make a 401k Withdrawal
You can make a 401k withdrawal after reaching 59-and-a-half years of age without receiving a penalty. Because you are only supposed to use funds from 401k plans once you reach retirement age, the government issues fees for early withdrawals.
However, the early withdrawal penalty may be waived under the following circumstances:
- Hardship, such as to pay for tuition, medical expenses or a primary home
- Qualifying disabilities
- Court orders