You’ve been hearing about 401(k)s for months, maybe years. From your parents, some “Financial Management” course you took at college for an easy ‘A’, and now the HR department at work sends a steady flow of emails about your company 401(k) which are confusing and usually deleted.
So why do you need a 401(k), really?
3 REASONS WHY 401(k)s ARE MORE IMPORTANT THAN EVER BEFORE
1 ) PENSIONS ARE HISTORY
Our parents used to have what’s called a “Defined Benefit” plan, more commonly known as a pension.
Pensions helped answer the most important financial question: “How do I get to a point where I can stop working?” This is also referred to as “Financial Independence.” It doesn’t necessarily mean that you stop working, it just means you don’t have to work if you don’t want to.
This is how pensions worked. Your parent and their employer contributed a certain amount of money to an account which was invested over time. When sufficient funds were available to retire and a certain vesting period had been met, a defined amount of money (the defined benefit) was paid out to your parent, immediately or gradually, based on factors like amount contributed, how long they worked for the company, etc.
Over the last 30 years, however, Defined Benefit plans have largely gone extinct, partly due to companies needing to remove the financial burden of these benefits. As a result, we have entered the age of the Defined Contribution plan, one type of which is, yep, the 401(k).
2 ) 401(k)s ANSWER THE BIG FINANCIAL QUESTION, WITH A CATCH
You should remember that 401(k)s aren’t something some guy made up. They’re a savings plan established by the Internal Revenue Tax Code, found in subsection 401(k) - hence the clever name. The rule permits tax-deferred funds to be directed to your 401(k) account from your company paycheck and the funds are invested in various types of assets.
However the “payout” to you is not an amount defined by your employer, as it was with a pension. It’s now a factor of:
- How much you invested
- How often you invested
- How long you left it to grow
- How you invested it
Yes, your 401(k) still help answer the big financial question, but it’s all up to you.
3 ) THE 401(k)’s UNIQUE ADVANTAGES
You may be thinking, “There are plenty of other ways to grow wealth.” And you’re right!
- Real estate investing
- Starting a small business
- Stuffing cash under your mattress
- Your Beanie Baby collection
These and other means of growing wealth may have their place (probably not your Beanies Babies), but 401(k)s were created to help you get to financial independence more easily. Here are seven key advantages:
Money put into your 401(k) is tax-deferred, meaning each dollar of contributions goes in before any taxes have been taken out. This allows more of each and every one of your dollars to work now, for longer, before taxes are paid.
Your investments are not taxed as they continue to grow in your 401(k), even when investments are bought and sold. Taxes are paid on the money you’ve contributed and earned once you take money out of your 401(k).
Matching Employer Contributions
Many employers who provide 401(k) plans offer matching contributions up to a certain percentage of your salary. That’s free money, folks, and too many 401(k) holders leave it on the table.
Because 401(k)s were established by the government and have been widely adopted by many businesses, chances are good if you start work at any mid or large size business they’ll probably have a 401(k) and an HR group or manager to help you get started.
Within your 401(k) you select investments, typically choosing from mutual funds and index funds. A big virtue of fund investing is instead of all your money being invested in one business, you are invested in hundreds or even thousands of businesses within one fund. This minimizes the risk of losing a significant amount of money if one company goes under.
Many 401(k) mutual funds carry very low fees, which are the mutual fund’s management and administrative costs.
Liquidity explains the ease of buying or selling a particular asset without affecting its price. The more liquid, the easier it is to buy or sell without a big price movement. Investments like mutual funds in your 401(k) are highly liquid. Most mutual funds can be sold in a few days day.
WHY SIMPLY HAVING A 401(k) IS NOT ENOUGH
So maybe you’re thinking, “Yeah, I’ve opened my 401(k) and I’m feeling pretty good about it.” That’s great, however, simply having a 401(k) isn’t enough. Two big problems exist for most 401(k) holders.
First, 401(k)s are confusing. I’ve heard questions like:
- How much do I contribute?
- What if I over-contribute?
- Do I have to pick my investments?
- How to pick investments?
- Do my investments need to change over time?
- Do I choose a regular 401(k) or Roth 401(k)?
- What if I need to take money out?
This doesn’t include how you handle multiple 401(k) plans, such as when you change an employer. Each 401(k) plan administrator does things a little bit differently than the other.
Second, 401(k)s are underutilized.
Most savers don’t save enough, and their saving activity is inconsistent. When financial markets, like the stock market, go down, they either stop contributing or make the common mistake of taking their money out. Savers tap into their 401(k)s early for all kinds of expenses: vacations, car purchases, even simple day-to-day expenses.
Your 401(k) is an incredible tool. I hope this and future articles can help you make sense of it and maximize its full potential.