Have you ever thought about what you plan on doing when you retire? Where will you live and how will you make money? Even if you haven’t thought about it, making money in your old age won’t be that easy. Employers are hesitant to employ older individuals and there’s always the possibility that you may be pushed out of your current job when you reach retirement age.

A good idea is to have money you can withdraw from a savings plan, like a 401(k), which you will learn more about here.

401k plan basics

What Is A 401(k)?

A 401(k) is a long term investment, made on your behalf, by your employer for retirement. The money is taken out of your monthly salary and if you’re eligible, your employer will match the amount you’re contributing. This means that you will be saving whatever you contributed, plus the money your employer is willing to match. In most cases, you’ll have to be contributing between 3% to 6% of your gross annual income to be eligible for the match.

Matching your contribution simply means that your employers will add the same amount that you have to your 401(k) every year. Generally, employers will not exceed a match of 6% of your gross annual income. When you retire, you’ll have access to this money. However, there are ways to access your money before then.

It’s Not Really A Savings Plan…

People often mistake a 401(k) for a savings plan, when in fact, it is not. When you save, you receive a certain predetermined interest rate on the amount you’re saving per year. Depending on the type of savings plan you have, you may or may not be taxed, and you also may or may not have access to your money whenever you choose.

A 401(k), on the other hand, is a long term investment, meaning that you’ll receive capital gains, as well as dividends, on the amount you’ve invested. And unlike many savings plans, you won’t be taxed on your total contribution. That’s only if your contribution doesn’t exceed $18,000 per year. With a 401(k), you’ll receive a much larger return than you’d receive with a regular savings plan. When you do withdraw from your 401(k), you’ll have a lot more money than what you’ve been putting in annually, due to the capital gains and dividends you’ve accrued.

How Much Should You Invest And Where?

For your 401(k) to be truly effective, you’re going to want to invest more than 3% of your gross annual income. This way, you’re receiving your contribution plus the money your employer is required to match. There are also several different investment options available for you to invest your 401(k) in, including money market funds, blended-fund investments, bonds or managed incomes, target-date funds and stock funds.

To determine which is best for you, you’ll need to do research on the risk and return associated with each fund. Riskier investments generally reap higher returns and vice versa.

401(k) Withdrawals And Loans

If the need arises, you will be able to take out a loan from your 401(k), depending on the type you have and the terms you’ve agreed to. Some 401(k)’s allow investors to borrow for any reason, but with some, you’re only allowed to take out a loan for specific reasons. To know if you can take out a loan from your 401(k), you’ll need to know what you initially agreed to.

The good news is you won’t pay tax on the amount you borrow and you can borrow up to 50% of your overall balance or $50,000, whichever is less. When it’s time to repay the loan, you’ll only pay 1% interest and you’ll be able to pay it off over 5 years. The only other time you can withdraw from your 401(k) is when you retire. This means you’ll be able to make withdrawals, penalty free, from age 59 and a half. But you must start withdrawing before 70 to avoid being penalized.

Tax And Fees

You won’t pay tax on the money you contribute to your 401(k) if you’re contributing less than $18,000 a year before you’re 50, and $24 000 a year when you reach 50. You will, however, pay tax when you decide to withdraw money from your 401(k) before you reach retirement age. When you withdraw from your 401(k) before retirement, you’ll usually pay a 10% fee on top of income tax, although there are exceptions. This percentage will be deducted from the total amount you’re withdrawing, including the amount you’ve received from capital gains, as well as dividends.

Final Words

Your 401(k) will only work if you make the most of it. If you contribute regularly and stay committed to investing, you can make use of your employer’s mandatory or incentivized contributions.

When you finally reach retirement age, you’ll have a nest egg you can use to subsidize your living and you won’t be forced to continue working just to keep up with your current lifestyle and bills. A 401(k)’s terms and conditions can be very confusing, so it might be a good idea to talk to a professional before you start investing.