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What Is A 401k For Dummies

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What Is A 401k

401k for Dummies – What is a 4o1k?

A 401k is an employer-sponsored retirement account. It allows an employee to dedicate a percentage of their pre-tax salary to a retirement account. These funds are invested in a range of vehicles like stocks, bonds, mutual funds, and cash. Oh, and if you’re curious where the name 401k comes from? It comes directly from the section of the tax code that established this type of plan specifically subsection 401k.

Am I Getting Good Advice From My Financial Advisor

Good question! When you feel like you need a retirement investments for dummies guide, you probably arent confident in your ability to assess whether investment advice is useful or not.

And, frankly, you are not alone.

In a 2016 poll by the American Association of Individual Investors , only 2% of respondents claim to trust financial professionals a lot. While, 65% of respondents said they mistrust the financial services industry to some degree 15% say they trust them a little.

Here are a few things you can do to feel better about what your financial advisor tells you to do:

Ask Questions : Ask questions about their recommendations! And, more importantly, make sure you understand the answers. Does your advisor explain things in a way that leaves you feeling confused? If the answer is yes, then you might not have the right advisor. The role of an advisor is to help you feel confident about your money.

Understand Compensation: Make sure that you understand exactly how your advisor is compensated. Ideally you use a fee only advisor. You are paying them for their time and expertise. A fee only advisor is working for you and only you. However, some advisors earn commissions on the products they sell you. Commissions are okay, but not if the advisor is selling you something you dont need.

Try Out the Advice: Dont blindly trust that your advisor knows what they are doing. Vet their advice.

David Weliver|

Modified date: May. 14, 2021

Ugh. I know.

Both true.

Whats Ahead:

What Do I Need To Do On An Ongoing Basis To Keep My Money Safe

What you need to do will depend on your goals and how your money is invested. You might want to consider drafting an Investment Policy Statement on your own or with the help of a financial advisor. An IPS is a map for what to do when.

Just as with any stage of life, set it and forget it will not work for your retirement investing strategy.

  • You will need to rebalance your portfolio to your target asset allocation periodically, generally at least annually.

Beyond rebalancing your investment strategy will need ongoing monitoring, and potentially an update as well. An update in strategy may be needed in order to support your withdrawal needs or due to changes in your situation.

Flexibility is key watchword for investors during retirement.

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What Are The Rules For A Roth Ira

Roth IRAs are only available to people making less than $129,000 a year as an individual, or $191,000 for married couples. They have contribution limits of $5,500 a year, or $6,500 for those over 50. Unlike 401ks and traditional IRAs though, there’s no penalty for withdrawing part of your contribution early.

How To Plan For Retirement: Start Early

What Is A 401k Plan For Dummies

The first step in retirement planning is to start as early as possible. Today is the day to decide your future retirement date and begin planning from there. The earlier that you begin investing in your retirement fund, the more that your money can compound to allow you to take away a sizable investment by the time that you reach the age of 65.

This is yet another example of how the early bird gets the worm. Even if you only contribute a fixed amount into your IRA for 10 years and then contribute nothing for the next 30 years, youll still be better off than the person who delays starting a retirement account for 10 years and then contributes a fixed amount for 25 to 30 years.

If you are able to contribute to your retirement fund early and allow the money to grow, you will be earning more than someone who opens a retirement account later and still contributes monthly until retirement.

Also Check: How To Increase 401k Contribution Fidelity

Improving Your Chances Of An Ideal Retirement

Investing in a 401 gives you a chance at extra savings for your retirement years. The additional savings can mean the difference between merely surviving retirement and actually living it up.

Did you ever stop to think how much money youll need in retirement to keep up your current lifestyle? Most financial planners suggest that youll need at least 70 to 80 percent of your pre-retirement income. But many people may need closer to 100 percent, or more.

Some people think that their Social Security benefits alone will be enough to cover their retirement needs. The unfortunate fact is, you shouldnt rely on Social Security to finance your retirement. Financial security during retirement requires income from a variety of sources. Social Securitys current problems are serious, but the system was never intended to be the sole source of retirement income for Americans.

Try to estimate how big a retirement account youll need, and develop a savings plan to try to accumulate that amount. When you retire, youll have to manage your nest egg so that you dont run out of money before you die. Chapter 4 explains why and how to set up a savings plan for your 401 during your working years, and Chapter 9 looks at ways to make this money last after you retire.

What Is Your Risk Tolerance

Perhaps the most critical question you must ask yourself is what your risk tolerance is. Some people cannot cope with the ups and downs of the stock market. If that is you, you probably want to opt for a safer type of annuity, such as a fixed annuity.

If you are used to market fluctuations, then an indexed or variable annuity may suit you better.

Read Also: What Employees Can Be Excluded From A 401k Plan

For Financial Independence In Retirement

The 401 makes it easy to build wealth for retirement. Once you set your preferences, the work of saving and investing happens behind the scenes. Plus, you have tax savings and, possibly, matching contributions that expedite your savings momentum.

Here’s what it comes down to: The earlier you start contributing to a 401, the more you’ll get from its perks and the richer you can be when you retire.

Planning for retirement when you’re your own boss.

Plan For Long Term Care

401k for Dummies – 401k Explained for Dummies

Discussing long term care with your family is recommended before retiring. According to the recent research by the U. S Department of Health & Human Services, around 52% of Americans turning 675 today will develop a disability that will require long-term services and supports .

The cost of long term care services continues to increase each year. As seen in the table below, the average cost of a semi-private room in a nursing home is $85,775 annually while a private room in a nursing home costs $97,455 annually. Opting to pay for this out of the pocket will most likely put you in the losing end wiping out your retirement funds or worse, youll become a financial burden to your loved ones.

Using ALTCPs long term care planning tool can help you prepare for your future long term care needs. Also, help you understand the ins and outs of long term care insurance before you make a purchase.

Read Also: How Do I Know Where My 401k Is

How Important Is Investing To My Financial Well

Investing is one piece of the retirement puzzle, an important piece, but not everything.

Sometimes people think that saving and making the right investments is all they need to do. But, there are a lot of other considerations that, depending on your circumstances, have a more or less profound impact on your financial well-being.

However, making the right investments is actually one of the most straightforward ways to increase your wealth. You have lots of different options and not investing is actually akin to burning up your money why not get returns on what you already have.

If you have money, make it work for you!

Taking Withdrawals From A 401

Once money goes into a 401, it is difficult to withdraw it without paying a tax penalty.

“Make sure that you still save enough on the outside for emergencies and expenses you may have before retirement,” says Dan Stewart, CFA®, president of Revere Asset Management Inc., in Dallas. “Do not put all of your savings into your 401 where you cannot easily access it, if necessary.”

The earnings in a 401 account are tax-deferred in the case of traditional 401s and tax-free in the case of Roths. When the owner of a traditional 401 makes withdrawals, that money will be taxed as ordinary income. Roth account owners have already paid income tax on the money they contributed to the plan and will owe no tax on their withdrawals, as long as they satisfy certain requirements.

Both traditional and Roth 401 owners must be at least age 59½or meet other criteria spelled out by the IRS, such as being totally and permanently disabledwhen they start to make withdrawals.

Otherwise, they usually will face an additional 10% early-distribution penalty tax on top of any other tax they owe.

Some employers allow employees to take out a loan against the money they have contributed to a 401 plan. Basically, they’re borrowing from themselves. If you consider this option, keep in mind that if you leave the job before the money is repaid, you’ll have to repay it in a lump sum or face the 10% penalty for an early withdrawal.

Read Also: Can You Transfer 403b To 401k

What Are Your Needs

Estimate your monthly living expenses before deciding on an annuity. Identify all sources of income you can expect before relying on a potential monthly annuity payout. Once you have determined how much you need at a minimum, you can inform your financial advisor so they can find you a suitable product.

Youre Our First Priorityevery Time

Updated Learning: How To Invest In A 401k For Dummies

NerdWallet, Inc. is an independent publisher and comparison service, not an investment advisor. Its articles, interactive tools and other content are provided to you for free, as self-help tools and for informational purposes only. They are not intended to provide investment advice. NerdWallet does not and cannot guarantee the accuracy or applicability of any information in regard to your individual circumstances. Examples are hypothetical, and we encourage you to seek personalized advice from qualified professionals regarding specific investment issues. Our estimates are based on past market performance, and past performance is not a guarantee of future performance.

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Also Check: Should I Convert My 401k To A Roth Ira

Protect Yourself From Inflation

The inflation rate not only plays an integral part in the economy, but it can directly affect your monthly living expenses over the length of an annuity term. The standard benchmark for the average annual inflation increase is roughly 2%. However, in 2021, inflation has skyrocketed by over four percent in the first half of 2021 alone. The rising cost of living needs to be factored into your monthly annuity payout. An income annuity with an inflation rider can help offset these costs.

A Beginner’s Guide To Understanding 401k Plans

The word 401k is synonymous with retirement, but how many of us actually know all the rules around 401k accounts? We’ll walk you through all the finer details, but we also know you’re busy, so we’ve also whipped up this handy table of contents for you, too. Feel free to self-serve some of the most frequently asked questions about 401k plans, or binge it all, top to bottom.

Now, onto the good stuff:

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Advantages Of A Roth 401k

  • Contributions are pre-taxed, which means withdrawals are tax-free. If you plan to be in a higher income bracket when you retire than are you now and if this plan comes to fruition, this would reduce your tax bill when you retire.
  • You never know when income taxes may go up. Paying taxes on your contributions now may mean a lot of savings if income tax rates go up or if the structure of everyones tax brackets change in a way unfavorable to your future situation.
  • Many employers match your contributions up to a certain level. This is essentially like free money. However, many companies put restrictions on when this match is fully considered available for you to withdraw even if you meet the distribution requirements. This limitation of when you fully possess the funds is known as vesting.

Invest In Safe Bets And Blue

401K for Dummies – A Beginners Guide to 401K Plans

Certain asset types are more secure than others according to their historical performance. Index funds that track a diverse basket of securities tend to perform well over time and net reliably positive returns in the long run.

For example, the S& P 500 fund is a benchmark index tracking Americas 500 largest publicly traded companies. Any investor can buy a share of the S& P 500 fund, each of which represents a small ownership stake in each of the companies held within the fundthese include mega-cap firms such as Amazon, Walmart, and Apple.

The average inflation-adjusted performance of the S& P 500 is about 7% per annum. That means we can assume an initial investment of $10,000 will practically double after 10 years in the market. However, as demonstrated below , the S& P 500 suffers from high volatility, with some years experiencing drastic lows followed by sharp highs.

Fig.1. Source: Investopedia

Retirement investors often cannot afford to allocate all their capital to risky investments. Although index investing is a viable strategy for many, more risk-conscious investors should consider safer assets that experience less volatility year over year, such as:

Also Check: How Much Should I Put In My 401k

Rules For Withdrawing Money

The distribution rules for 401 plans differ from those that apply to individual retirement accounts . In either case, an early withdrawal of assets from either type of plan will mean income taxes are due, and, with few exceptions, a 10% tax penalty will be levied on those younger than 59½.

However, while an IRA withdrawal doesn’t require a rationale, a triggering event must be satisfied to receive a payout from a 401 plan.

The following are the usual triggering events:

  • The employee retires from or leaves the job.
  • The employee dies or is disabled.
  • The employee reaches age 59½.
  • The employee experiences a specific hardship as defined under the plan.
  • The plan is terminated.

Actual Deferral Percentage Test

The actual deferral percentage test or ADP test is our first nondiscrimination test. This test compares average NHCE salary deferral percentages to the average for the HCEs, and naturally involves the calculation of these numbers.

Calculate these two percentages:

Step #1: Calculate Annual HCE Deferral Rate

Gather together your HCE contribution rates and average them. Display as a percentage.

Deferral Rate = Salary Deferral / Total Compensation

Step #2: Calculate Annual NHCE Deferral Rate

Gather together your NHCE contribution rates and average them. Display as a percentage.

Deferral Rate = Salary Deferral / Total Compensation

Step #3: Compare and Make Your Determination

Compare the percentages and be sure that they fall within the acceptable ranges.

The annual maximum HCE deferral rate is based off the contribution rates of your NHCEs. Heres how to determine the maximum HCE rates:

Recommended Reading: How To Rollover Fidelity 401k To Vanguard

How Does A 401k Work For Dummies

In simplest terms, a 401 is an account like a savings account that you put money into for the purpose of having that money to use when you retire. The money you put into your 401 is not taxed right now. That means if you contribute to a 401 this year, youre going to pay less in income taxes this year.

Disadvantages Of A 401

What Is A 401k For Dummies

While a 401 is a great way to save for retirement, here are a few drawbacks to be aware of:

  • Fewer options for mutual funds. Your employer hires a third-party administrator to run the companys retirement plan. That administrator determines which mutual funds you can invest in, limiting your options.
  • Waiting period. If youre new to a company, you may have to wait a certain length of time to participate in a 401 plan.
  • Required minimum distributions . You cant leave your money in your 401 forever. Beginning at age 72, you must start withdrawing a certain amount of your savings each year, or youll pay a penalty.2 Alsothere are penalties for withdrawing money before age 59 1/2. Either way, Uncle Sam wants his share!

Lets turn to the Roth IRA, and then well compare the two.

Read Also: When Can You Use Your 401k

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