Understanding Your 401(k)

Planning for retirement sucks. In a world filled with instant gratification, who wants to delay the fun? Nobody – which is why governments have nudged workers to save for retirement. If one defers the salary they receive, then the government will defer the taxes owed as well. The most common salary deferral plan is the 401(k).

I already told you that 401(k) plans are a must (unless of course you’re not offered one). With the future of Social Security unknown, 401(k)s are the primary vehicles that are going to get people through retirement.

Salary deferral plans are typically going to be self-directed. In the past, your company would decide how to invest the money set aside for your retirement. Now that it’s partly your money going in, you’re going to have control. You are in the driver’s seat and can select investments that you think will get you where you want to go. Unfortunately, with control comes responsibility.

As stated above, the government is going to defer the taxes owed on the money you invest in your traditional 401(k) plan. The income taxes are postponed until you withdraw (hopefully after you retire).

If you are in a Roth 401(k), the amount you defer doesn’t cut down on your taxable income. However when you withdraw after retirement (after 59 ½) the income you receive is tax-free.

Where will tax rates be in 30-40 years? It’s hard to know. That’s why it’s best to be prepared for several scenarios. Since income is limited in retirement years, a lot of people end up paying a lesser tax rate than they did in their working years. For this person, a traditional 401(k) is going to make sense. Though I’ve heard strong cases for each side.

The Tax Benefits

Any money invested in your 401(k) will not only go in tax-deferred but will also GROW tax-deferred. What this means is that your money will be working harder for you because it will compound at a faster rate since all money is reinvested and not cut down via taxes.

No matter how much your investments increase in value over time, you won’t have to pay capital gains tax on any increases in account value. Just remember, if your account loses value you’ll also be unable to claim these losses as well. But let’s be serious, who’s going to lose money!?! Our economy is hot!

Vesting

“Bulletproof vests protect guys from bullets. Sweater vests protect guys from pretty girls.”

That’s one of my favorite jokes about vests. I guess that’s not saying a lot because I can only think of one vest joke off the top of my head. Anywho – what on Earth is vesting?

As you’re contributing money into your 401(k), any money that you put in is still yours; but the same is not true for the money your employer has matched. There is typically a period of time before you are fully vested – meaning you have legal rights to that cash money.

There are three types of vesting:

Immediate

Quite obviously, this means you have legal rights to any money that is contributed to your 401(k), whether it came from you or your employer.

Cliff

This means that you are entitled to 100% of the 401(k) contributions after x number of years. Typically, I’ve seen the vesting period of 3 years – as this is the requirement by law.

With defined benefit plans where there are not matching contributions, this goes to 5 years you must stay in order to receive the benefits. Honestly, who stays at a company for 5 years anymore?

Graded

This gives you rights to your account over time. You will receive 20% of the matched contributions by the second year and be fully invested by the sixth year. What happens in between is anybody’s guess.

Have you set up your 401(k)? Are you already fully vested?

This post was written by A. Blinkin.


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