What is the 401(k), advantages and how it works in the United States
If you are looking to understand what the 401(k) is, how it works and what it is for, in a simple, clear way and with examples, you have come to the right place.
In this article, we will explain in a simple way what this important retirement plan is and how it works, especially relevant for Hispanics living in the United States.
Additionally, you will learn how the 401(k) can become a powerful tool to secure your financial future, and that of your family in the United States.
What is the 401(k)?
To get started, let’s clarify what a 401(k) is. In a few words, it consists of a retirement savings plan that gives you the opportunity to build a financial fund for when the time comes to stop working.
It is important to note that the name “401(k)” comes from section 401(k) of the United States Internal Revenue Code, which sets the rules for these types of plans.
Let’s use the example of Marta, a young professional in the United States who just got her first job at a company that offers a 401(k). What does this mean? That she can put a portion of her salary toward this retirement plan, and that money will be invested to grow over time.
And it is that one of the advantages of the 401 (k) is that you control how much money you want to contribute from your income, and it is flexible in terms of adjusting your contributions in the future.
Marta decides to start with a small amount of 5% of her monthly salary, which is $100 a month to start.
In addition, Marta’s company offers a “match” or counterpart of 50% of the contributions, up to 6% of her salary. This means that for every $100 Marta contributes, her employer adds an additional $50 each month!
It’s like an added gift for her retirement, and she wants to make the most of this opportunity.
Returns on money invested in 401(k)
Now, with compound interest, you will not only earn income on the initial contributions, but also on the income generated previously. The sooner you start saving, the more time your money has to grow.
So once Marta accumulates a significant amount in her 401(k), she will have the option to diversify her investments. She can choose from different investment options, such as US stocks , bonds or mixed funds, to suit her risk profile and financial goals.
How the 401(k) works in the United States
The 401(k) is an affordable retirement plan for many workers in the United States. To participate, you generally must meet certain requirements, such as working full-time or part-time for an employer that offers this plan. Once you’re eligible, you can start making contributions.
According to data from the Employee Benefits Research Institute (EBRI) , Hispanics contribute about 6% of their wages to their 401(k) plans.
Match Employers to 401(k) Retirement Plans
The employer’s match can vary, but a typical contribution is 50% of the employee’s contributions up to a maximum of 6% of salary.
For example, if you make $40,000 a year and contribute 6% of your salary to your 401(k) (that’s $2,400 a year or $200 a month), your employer would add 50% of that amount, which equals $1,200 additional per year or $100 per month.
In addition, approximately 80% of employers that offer 401(k)s also offer some type of “match” in employee contributions.
Taxes and 401(k) retirement plans
In the first example we used of Marta, we must add that the contributions she makes to her 401(k) are not taxed at that time.
This means that for every $100 you contribute, your taxable income is reduced by that amount. As a result, you’ll pay less tax on your current paycheck.
However, it is important to note that there are limits on the amount you can contribute annually, established by the Internal Revenue Service (IRS) .
In 2023, the contribution limit for those under 50 years of age is $22,500, while for those over 50 years of age, it is allowed to contribute up to $28,000 per year. If you can afford to save more and reach the ceiling, you’ll be maximizing the growth potential of your retirement savings.
When are taxes paid on the money contributed to the 401(K) plan?
Tax on funds in a 401(k) plan is paid when the money is withdrawn during retirement.
When you reach retirement age, generally starting at age 59, and begin withdrawing funds from your retirement account, those withdrawals are considered income and are subject to federal and state taxes, as applicable.
The advantage of having your 401(k) savings grow tax-free lies in the tax deferral.
As long as the money stays in the plan, you don’t pay taxes on the earnings generated by your investments. This allows compound interest to work in your favor, since reinvested earnings also generate more returns without being affected by taxes.
In other words, by not having to allocate part of your income to pay taxes each year, your savings have the opportunity to grow more quickly.
The longer you leave your investments in the 401(k) and they continue to earn tax-free earnings, the greater the cumulative effect and the greater the amount of money available for retirement.
How to invest your 401(k) money and when
Within a 401(k), you have options to invest your money in different funds based on your risk tolerance and financial goals.
Investment options can include stocks, bonds, diversified mutual funds, and more. By diversifying your investments, you reduce risk and increase the chances of earning higher returns over the long term.
Here’s how you can invest your 401(k) and when the time is right to do it:
Within your 401(k) plan, you’ll find a variety of investment options to choose from. As we already mentioned, these options usually include:
- mutual funds,
- Index funds, among others.
Each of these options has its level of risk and potential return. It is important that you understand your financial goals and risk tolerance to select the investment mix that best suits your needs.
Diversification is a key 401(k) investing strategy. Rather than putting all your eggs in one basket, diversifying means spreading your investments across different assets and asset classes.
This helps you reduce risk and increases the chances of getting better returns in the long run. For example, you can spread your investments across stocks from different companies, bonds from different issuers, and funds that track different market indices.
The investment horizon is the length of time you plan to keep your 401(k) investments before you need to withdraw the funds for retirement.
If you are in the early stages of your career and retirement is far away, you can generally take more risk on your investments, as you will have time to recover from potential market downturns over time.
As you get closer to retirement, it’s a good idea to gradually reduce your risk and focus on more conservative investments to protect your accumulated savings.
Rebalancing is an important practice in 401(k) investing. Over time, your investments may become unbalanced due to different returns on various investment options.
It is essential to periodically review and adjust your investments to maintain the asset allocation that best aligns with your goals and risk tolerance. Rebalancing helps you maintain a balanced portfolio in line with your financial goals.
Finally, if you don’t feel comfortable or confident making investment decisions on your own, consider seeking professional advice.
A financial advisor can help you understand your investment options, design an appropriate investment strategy, and track your 401(k) plan over time.
An advisor will provide you with recommendations based on your individual circumstances and help you make informed decisions to achieve your retirement goals.
Create your first 401(k) retirement fund
In short, the 401(k) is an invaluable tool in securing your financial future. With tax benefits and the potential for growth over time, this retirement plan can give you the peace of mind you need in your golden years.
So, now that you know how the 401(k) works, it’s time to start your own, take advantage of the advantages that companies offer in the United States, and have a long-term mindset.