One of the most effective tools for a comfortable retirement is a 401K plan, whether it is of the employer-sponsored or solo variety.
These plans have many benefits, including offering a range of investment options—mutual funds, stocks, bonds, and even company stock. This variety allows you to diversify your portfolio, which is a key strategy for managing risk.
Here’s what you need to know about 401Ks and how to maximize them.
How does an employer-sponsored 401K work?
An employer-sponsored 401K plan lets employees save and invest a portion of their pre-tax pay. Employers often match a portion of employee contributions—or offer a flat contribution amount. In a company 401K format, employees under the age of 50 can contribute up to a certain amount each year (limits are increased regularly), and employers can pitch in up to 25% of their employees’ compensation for a combined maximum amount. The most common method for employers is to offer a match. On average, these employer contributions are between 4% and 6% of an employee’s salary.
How does a solo 401K work?
If you’re self-employed or a small-business owner with no full-time employees (other than a spouse), a solo 401K is a great way to save for your golden years. One major difference between this plan and an employer-sponsored 401K is how contributions are handled—the amounts are the same but divvied up differently. In a solo 401K, you can act as employer and employee and contribute a maximum combined amount—a cap as an employee and up to 25% of your total compensation as the employer.
*For both employer-sponsored and solo plans, there are catch-up contributions for those over 50 (with an even bigger catch-up if you’re between 60–63).
Tax benefits and compound growth
One of the most attractive features of a 401K is tax-deferred earnings. Investments in both employer-sponsored and solo 401Ks aren’t taxed until you withdraw the money, usually after age 59½. This allows your investments to grow faster than they would in a taxable account, since money that would have been used to pay taxes is being invested and earning returns. With compound interest, this can lead to exponential growth in your retirement savings. This pre-tax contribution means that the money put into the 401K reduces your taxable income for that year, potentially lowering the overall tax bill.
Possible pitfalls
While 401Ks offer significant advantages, there are potential drawbacks to consider. One is the limited control over investment choices compared to an individual retirement account (IRA). With a 401K, investment options are selected by the plan administrator, and while you can choose from this selection, it may not include all the assets you’d choose yourself. (You may not be able to take advantage of a hot stock tip, for example.) Also of note, you get dinged for early withdrawal—pulling money out before age 59½ will typically have a 10% early withdrawal penalty attached on top of regular income taxes. Finally, some 401K plans have high administrative fees or expensive investment options that will decrease your overall savings.
A 401K plan is a popular retirement savings vehicle that can grow exponentially, tax-free, during your working years. Just be aware of limitations on how you can invest as well as potential penalties and fees that can impede your progress.
If you have questions about 401Ks or are looking for general investment advice, contact an LPL Advisor* with SELCO Investment & Retirement Services. They’ll be happy to help.
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* Securities and advisory services are offered through LPL Financial (LPL), a registered investment advisor and broker-dealer (member FINRA/SIPC). Insurance products are offered through LPL or its licensed affiliates. SELCO Community Credit Union and SELCO Investment & Retirement Services are not registered as a broker-dealer or investment advisor. Registered representatives of LPL offer products and services using SELCO Investment & Retirement Services, and may also be employees of SELCO Community Credit Union. These products and services are being offered through LPL or its affiliates, which are separate entities from, and not affiliates of, SELCO Community Credit Union and SELCO Investment & Retirement Services. Securities and insurance offered through LPL or its affiliates are:
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