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Saving money is one of the most sound pieces of financial advice. It is something we learned about in school and applied in the “real world” once we landed our first paying jobs. Stashing away money for the future gives you freedom and provides you with a safety net should times get tough or when you need cash for a home, automobile, or college tuition. Of course, having money in the bank can also come in handy in the event of a medical emergency or an unexpected expense.
As you know, saving for the future takes a lot of planning and discipline. And, not everyone is able or willing to make the sacrifice. Morning lattes, streaming television channels, excess restaurant visits, credit card payments, and extravagant spending habits can chip away your savings and net worth. Research indicates that one in five Americans are not saving money at all, and over half do not have enough money for retirement. The good news? Many businesses, perhaps yours, offer their workers the option to participate in a retirement plan. In this Balboa Capital blog article, we explain what a 401(k) plan is, how it works, and how it can benefit you.
What is a 401(k) plan?
This employer-sponsored plan allows employees to set aside a portion of their salary on a pre-tax basis, which can then be invested in various mutual funds and other retirement options. These investments grow tax-deferred until the time of withdrawal. A plan consists of the employee’s contributions and the employer’s matching contributions. Not every company matches a portion of what you save, so keep this in mind.
Participating in a 401(k) plan is an excellent way to save money because it runs on auto-pilot and requires less money-saving discipline. The amount you contribute is automatically deducted from your paycheck and invested. Over time, you will see your account grow. A retirement plan may fill the void if you have difficulty saving money on your own.
What types of plans are available?
Traditional and Roth are the two main types of 401(k) plans. That said, there are other types available, such as Safe Harbor, SIMPLE, and Solo. There are many considerations when deciding which type is best for you based on what plans your employer offers. The decision of which plan to invest in depends on the following factors: age, income, and investment goals.
Traditional 401(k) contributions are tax-deductible, which means you do not have to pay taxes on any gains or interest until you withdraw the money. Plus, your contribution amount might be eligible for a tax deduction each year. So, you are getting a tax break up front, which can help lower the amount you are required to pay on your income tax return. In addition, if your investments perform well, you can avoid taxes on dividends and capital gains until you start making withdrawals.
A Roth 401(k) is different than a traditional 401(k) in that you contribute post-tax money to the account. Although you are not reaping the benefits of avoiding tax on your contributions, your account will grow tax-free, and you will be able to withdraw funds without having to pay taxes when you retire at age 59 ½ or older. If you have contributed to a Roth 401(k) for a minimum of five years, you can withdraw your contributions before the age of 59 ½ without having to pay any penalties. In addition, certain hardships may allow you to withdraw money without being subjected to a penalty. These include medical expenses that top 10% of your gross income, serving in the U.S. military, or becoming permanently disabled.
2022 contribution limits.
One of the most common questions people ask themselves is, “how much should I contribute to my retirement plan?” Of course, there is no right or wrong answer to this question, as everyone has their unique financial situation and retirement goals. In addition, some people start saving early in life, and others start later, at age 40 or older. However, most retirement planners recommend that you contribute at least a nominal percentage of your income toward your retirement, as this will benefit you in the future.
In 2022, the maximum contribution limit for individuals is $20,500 a year, or $27,000 a year if you are 50 or older. Your employer’s contributions are on top of these limits if they offer them. Please note that all retirement limits are set by the Internal Revenue Service (IRS) and are subject to change each year. Therefore, it is recommended that you consult with a financial advisor to get the latest information and to help you make the best investment decisions based on your individual needs.
We think it would be beneficial to illustrate how a 401(k) plan works, so here is an example. A travel company offers a 50% matching program to Billy, its new marketing director. Billy’s pre-tax paycheck amount is $3,000, so he decides to make an 8% pre-tax retirement contribution ($240) from each paycheck. Billy’s monthly contribution totals $480, and his employer contributes an additional 50%, or $240. So, he is saving $720 each month, or $8,640 each year. Billy invested his money into high-growth mutual funds that generated a 10% return, so his portfolio topped $9,504 after one year ($8,640 plus $864).
Should your business offer a retirement plan?
The 401(k) plan has many benefits for employers and employees. For example, employers may offer a matching contribution to their employee’s contribution up to a certain percentage of salary. This is an incentive for employees to save more and helps reduce turnover rates because it provides valuable benefits to workers. Plus, matching contributions may qualify as ordinary business expenses and be tax deductible, which can lower your business’s tax liabilities.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.