An easy way to save for retirement is through a 401(k) plan. It allows employees to set aside funds before tax comes due, and most employers offer a matching contribution. Employees can choose from traditional 401(k) contributions, which get a tax break upfront and reduce their taxable income, or Roth 401(k) contributions, which are after-tax investments but offer a tax break when they withdraw. A financial advisor can help with the selection process.
Tax-free withdrawals in retirement
A significant consideration for investors who plan to retire someday is how they will withdraw from their various retirement accounts. Consider tapping taxable, tax-deferred, and tax-free assets in the order that makes the most sense for your circumstances. For example, you might pay a lower rate of federal long-term capital gains taxes on withdrawals from a Roth 401(k) or IRA than on distributions from a traditional IRA or 401(k). Personal 401(k) plans offer a better way for the self-employed to save for retirement than the SEP IRA or SIMPLE IRA. For example, a solo 401(k) allows for a higher contribution level and lets individuals save for retirement with employer and employee contributions. The other main difference is that a 401(k) allows catch-up contributions for those age 50 and older, while SEP IRAs do not. All withdrawals from a traditional 401(k), SEP, or IRA account are subject to income tax (unless made from a Roth account, which is allowed only for qualified distributions). Those withdrawals can also be subject to a 10% penalty for amounts taken before age 59 1/2. Managing your retirement distributions in the most tax-efficient manner is crucial for a successful retirement. This is important because most of your retirement income will likely come from different accounts’ withdrawals. A tax-efficient withdrawal strategy can make a substantial difference in your retirement life, helping you enjoy financial stability and security rather than struggling to make ends meet.
One of the most significant advantages of 401(k) plans is that you only pay taxes on investment gains, interest, and dividends when you withdraw the funds in retirement. (Unless you have a Roth 401(k).) This deferral allows for more wealth to accumulate over time through compounding. In addition, the amount of money you contribute to a 401(k) plan is deducted from your paycheck before it is subject to income tax. This means that you receive an immediate tax break on your contributions. This may seem insignificant when you are young, but it can increase as your earnings and tax rate increase. Most employers offer a range of investments in their 401(k) plans, including stocks, bonds, and mutual funds. Many also provide target-date funds that invest in a mix of stocks and bonds based on your anticipated retirement date. You will be automatically enrolled in the plan’s target-date fund unless you choose otherwise. Some 401(k) plans require you to work for a certain amount before becoming vested in employer-matching contributions. However, this vesting only applies to the employer’s matching contribution, not your contributions. This makes 401(k)s a perfect option for employees who want to avoid losing their employer’s match by switching jobs or retiring early.
Employers often offer to match employee contributions to encourage saving. It also incentivizes companies to retain their top talent since the company’s matches aren’t taxed the same as the employee’s contributions. To take advantage of this, however, it’s essential to understand the limits and vesting schedule associated with a company’s matching program. Some 401(k) plans have a partial match, where the employer will contribute only up to a percentage of an employee’s salary. Sometimes, the employer will also offer a “cliff” or “graded” vesting schedule, where the employee must wait a certain amount of time before becoming fully vested in the employer’s contribution. The average employer match in a 401(k) plan is 4.5% of an employee’s annual salary, according to data from 2022. While this may seem like a little, it’s worth taking advantage of. Ensure you’re saving enough to reach your 401(k) maximum.
Most 401(k) plans offer investment options, including mutual and exchange-traded funds. Choosing which ones you invest in depends on your goals and risk tolerance. Consider your time horizon and whether or not you want to diversify your portfolio. In addition to selecting the best-performing investments, you should pay attention to the fees and expenses associated with your 401(k) account. These fees come from your returns and can reduce your long-term investment return. Look for low-cost funds that track the indexes you want to invest in, such as passively managed S&P 500 funds with expense ratios of just a few hundredths of a percent. It’s important to remember that all investing is risky, but a diversified portfolio can help you minimize risk and increase your long-term returns. Investing in a balanced mix of stocks, bonds, and cash is crucial when planning for retirement. A general guideline to follow is to save enough funds in your 401(k) account and other sources of income, such as social security and a pension so that you can replace roughly 80% of your current income after retirement.