5 Things You Should Know Before Investing in a 401(k) Plan

If you are interested in this employer-sponsored plan, here are 5 factors that can help you maximize its potential benefits.

If you have just started your first full-time job, retirement might be the last thing on your mind. However, cultivating a good habit in the early stage of your career will significantly affect how and when you are able to retire. One of the key things that you need to consider in your job, apart from the salary, is your compensation benefits. Several companies may offer employer-sponsored retirement plans and other incentive programs to boost your retirement savings. 

A 401(k) plan is the second most popular product used for retirement in the United States, according to a recent survey by Statista. If you are also interested in this employer-sponsored plan, here are 5 factors that can help you maximize its potential benefits:

Time Value of Money

It is one of the most basic principles of financial planning. The sooner you start investing in a 401(k) plan, the more you will get a head start on your long-term financial security. Under this plan, your money along with any income or capital gains from this investment, get compounded on a tax-deferred basis. So, even a tiny contribution, combined with the contributions from your employer, has the potential to grow to a substantial nest egg over time.

Traditional vs. Roth Plan

Under a traditional employer-sponsored 401 (k) plan, the employees save and invest a portion of their gross salary before taxes are taken out up to IRS prescribed limits, according to E.H. Thomson & Co. Any taxes on this amount are not liable to be paid until it is withdrawn from the individual account at retirement or other distributable events. On the other hand, under a Roth 401(k) plan, any amount the employees contribute doesn’t reduce their current taxable income or income tax bill. However, distributions at the time of retirement are usually tax-free, subject to certain restrictions and considerations. 

You should consider your age, income, and expectations for your future tax bracket while choosing between a traditional and Roth 401(k) plan.

Contribution Limits

The federal government sets the limit for contributions to an employer-sponsored 401(k) plan annually. In 2020 and 2021, participant contributions were capped at $19,500, according to the information published by the IRS. If you are age 50 or older, you may contribute an extra $6,500 in both 2020 and 2021 as a “catch-up” contribution. As this limit often changes from year to year, you should review your contributions at least annually to ensure you are maximizing your savings.

Participation Options and Incentives

Some companies often automatically enroll their employees in a retirement plan and select a default contribution amount and investment option. However, you can choose the contribution rate and investment approach that is best for you. Also, it is your responsibility to manage your account on an ongoing basis. You may even get some incentives from your employer to save by offering matching provisions.

Vesting Restrictions

Although the amount you contribute to a 401(k) plan belongs to you, any amount contributed by your employer on your behalf belongs to your employer until you are vested. This vesting schedule is determined by your employer. So, you should be aware of its restrictions so that you don’t unintentionally lose out on a substantial amount of money.

This plan is a valuable savings tool and can significantly increase your total compensation as your employer is also contributing on your behalf. Since you have to make several decisions while enrolling and participating in this plan, reach out to a trusted financial advisor for any help.

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