You’ve heard of a 401k plan, and chances are you may even already have one of these retirement plans in place. But, do you understand how a 401k works? If you don’t, you could miss out on some of the advantages that a 401k plan offers. The more you know about your 401k and how to manage it, the more you can reap the benefits of your plan in your retirement.
At Waters Hardy, we’ve had many clients come to us for advice regarding smart 401k planning and tax compliance considerations. We offer complete tax preparation services including building a strategic 401k plan that will serve you faithfully throughout your retirement.
Here are five ways to make your 401k work for you today, tomorrow, and the future.
What is a 401k Plan?
A 401k plan is named after the section of the Internal Revenue Code that created this plan. It is a retirement savings plan that is an employee-funded defined-contribution (DC) plan that gives workers a tax-advantage in a way to save for retirement. With a 401k, employees have the option to contribute a percentage of their income to the plan. Contributions are automatically taken out of your paycheck and are tax deductible.
Different Advantages of a 401k Plan
Any contributions you make to a traditional 401k are taken directly out of your paycheck before federal income taxes are withheld. This lowers your taxable income and may even put you in a lower tax bracket. Additionally, your 401k earnings accrue on a tax-deferred basis, meaning the dividends and capital gains that accumulate inside your 401k are also not subject to tax until you begin withdrawals. The idea behind the plan was that in retirement, you’ll likely be in a lower tax bracket than if you were taxed on the money now.
Some employers offer to match the amount you contribute to your 401k. Some even offer a profit-sharing feature that contributes to your 401k exactly what it says, a portion of the company’s profits. Taking it one step further, some companies even match your contributions dollar-for-dollar for up to the first 6%.
401k Contribution Limits
A 401k plan saves you much more money than an IRA from year to year. For 2022, the limit is $61,000. However, this doesn’t count the additional $6,500 catch-up amount for those aged 50 and older.
401k Contributions After Age 72
Unlike other retirement accounts, you can continue to contribute to your 401k past the age of 72. Also, along with a 401k, if you’re still working, you aren’t obligated to take mandatory distributions from the plan, provided you own less than 5% of the business that employs you.
Set up under the Employee Retirement Income Security Act (ERISA), 401k plans are generally protected from judgment creditors. Since the 401k plans legally belong to your employer, it is more difficult for the IRS to place a lien on the account, offering you protection from federal tax liens.
5 Ways to Make Your 401k Work for YOU
1. Save as Much as Possible Today
Most financial planners agree that you need to save 10% to 20% of your total earned income each year to maintain the same lifestyle during retirement. The best day to start saving is today!
- Compound interest
The earlier you start, the more time you give your money to grow. For example, just by starting to contribute ten years sooner than you might have otherwise, you can save nearly twice as much if you had waited to start saving.
- Saving is a habit
While you might not think you can afford to contribute any of your income initially, give it a try even if it’s a small amount. Eventually, it becomes a habit, and you won’t even think about it every month. It will feel good to see your account balance grow, and then you’ll want to keep contributing.
2. Take Full Advantage of Your Company’s Match
If you can’t maximize your annual contribution, put in enough money to benefit from a full company match. When your company matches you, it’s like getting free money. If you’re not meeting the company match, you could leave a lot of money on the table. The amount could directly impact your retirement lifestyle.
3. Avoid Early Withdrawals
If you withdraw money from your 401k before the age of 59½, you will have to pay income tax on the amount you withdraw. Which is a 10% early withdrawal penalty, and you lose the potential of compound interest. Depending on your tax bracket, this could cut your withdrawal in half! Even if you leave a company, transferring your 401k over to your new company is a better option than withdrawing early.
4. Make Future Increases to Your Savings
Even if you can’t afford to max out your contributions, make sure you at least increase the amount you contribute from year to year. One great benefit of 401k plans is that you can change your mind or update the contribution amount at any time. So, even if it’s small and gradual, set a goal of increasing your savings amount every year.
5. Choose the Right Investment Mix for Your Situation
Choose asset allocations that match your comfort level with risk as an investor with your investment timeline. By choosing to invest in a mix of stock and bond funds, you can minimize the risk of losing some of your 401k funds. Additionally, periodically rebalance your portfolio to ensure proper asset allocation.
Waters Hardy is Your Trusted Partner for Your Finances
Contribution limits, tax advantages, and your financial situation make it imperative that you regularly review your 401k plan’s performance and make changes to suit your needs better. This can be an overwhelming responsibility for many, especially considering the importance of keeping up with tax compliance and regulations changes.
A professional tax advisor can help you create a 401k plan and tax strategy that aligns with your retirement goals. The experts at Waters Hardy have a trusted reputation for partnering with clients to provide complete tax planning advice about optimizing your retirement savings plan.
Let’s discuss how we can help you develop a clearly defined 401k retirement plan that is strong, dependable, and customized to fit your needs. Contact us today.