Finance

How to use your 401K

By mlamoureux - December 20, 2017

Given how much energy many people put into talking about their 401(k), it’s pretty surprising how little people generally understand about their 401(k) — until it’s time to retire, that is.

A little refresher course: a 401(k) is an investment account that you contribute to over the course of your career. In many cases, your employer will share the 401(k) options they provide but may not explain which option may be the best one for you, which will require you to do a bit of homework. A 401(k) is a great way to grow your wealth over the course of your career, as contributing to it reduces your tax burden (money committed does not count as taxable income for that year of taxation) and employers often match your contribution, which encourages faster growth and larger numbers.

Since you can’t (or shouldn’t) take from your 401(k) before retirement (unless you become permanently disabled), you might as well be making smart contributions throughout your career. Even increasing your contribution by 2%, from, say, 7% to 9%, you could increase your 401(k) investment fund by nearly double. But let’s not get ahead of ourselves. Understanding the math is a long, complex process. Let’s walk before we run.

401K - THE BASICS

Credits: idkmen.com

Your 401(k) is an investment that is tax-sheltered. This means that the money in this investment is not taxed until it is removed. As it is designed as a retirement account or fund, you’ll pay a 10% penalty (as well as income tax) if you withdraw from your 401(k) before you’re 59.5 years old. However, keeping the money in the account is the point, because the untaxed sum of money will, over time, have the opportunity to grow in your 401(k) account, where it will potentially constitute a large portion of your retirement fund.

If your employer participates in contribution-matching, their commitments will likely range from half of your contribution to double your contribution. Either way, you’ll end up with free money in the end — though it’s probably advisable not to think of it as “free” money.

Contributing to your 401(k) is, for the most part, a safe way to grow your nest egg. If you have a stable income and you have the opportunity to, aim to take the highest matching plan available. If you can contribute 4% of your salary and your employer contributes half, then 6% of your salary will be going into your 401(k); if your employer contribution is double, you’ll get to commit 8% of your salary. (Also: don’t ever leave that job.)

An important thing to remember is if you change companies, your employer may close out your 401(k) account. In order to make a smooth transition, transfer the money out of your existing account as soon as you can or else you may incur extra fees or have to pony up thousands of dollars that you might not have.

WHERE TO INVEST

Credits: marketwatch.com

It usually depends on your employer, but two great firms to invest your money with are Fidelity and Vanguard.

Fidelity offers a wide array of investment opportunities for large companies, small business owners, and individuals alike. Their fund managers watch investment fund like hawks and provide lower expense ratio plans that are suitable for beginner investors, and also work with high earners to ensure that their investments are maintaining growth.

While Fidelity manages more 401(k) funds than Vanguard, it merits mention that Fidelity is run by owners, not clients. Any level investor should take that into account when deciding where you want your 401(k). If we are speaking in generalities, Fidelity is excellent for active traders who know more about the market and who have a general interest in finance, investing, and speculation.

Vanguard, which manages over $3 trillion in assets (yes, that was “trillion” with a “T”) is well-known in the business for its low cost investment management. Since it is client-owned (as a “mutual” company, Vanguard is technically owned by the funds under management), there aren’t any owners or boards who can theoretically affect your investment . Vanguard may have fewer funds than Fidelity, but the fees are miniscule in comparison — Vanguard’s management fees are incredibly low, which some say is proof positive of their commitment to low-cost investing and investors who are only starting out. Additionally, Vanguard offers educational material on asset allocation and retirement catered to fit your situation. If you’re a no-frills, passive-style investor, Vanguard may be the right fit for you, especially if you’re a set-it-and-forget-it type of investor.

At any rate, it pays to look at your 401(k), but the best advice is to contribute as much as you can with the highest matching contribution from your employer, and let it grow. Markets may change and that may be cause for alarm, but a slow and steady approach to your 401(k) can lead to a great retirement in the long run.