You got your first big grownup job and you get offered a 401(k). Sweet! But what does this weird number/letter combo actually mean? And how should you use it?
A 401(k) is a retirement plan that is offered by your employer. You can contribute money to it and in some cases, your employer might even provide a match of your contributions up to a certain percentage (typically 3 to 6%).
The reason the number/letter combo isn’t super creative is because it literally refers to section 401(k) of the Internal Revenue Code. The great thing about 401(k) contributions is that while you save for your future, you can save money on taxes in your present.
What you put toward your 401(k) is taken out of your paycheck before taxes are taken out. Your gross income is then lower which means you can pay less in taxes too. You also don’t get hit with any taxes on the gains you earn year over year, only when you withdraw your money at retirement age. By that time, your income will likely be lower so you’ll be in a lower tax bracket. It’s pretty much a win-win.
If you want to get started saving for retirement through a 401(k) at your job, you’re probably wondering how much you should contribute. That of course, depends on your goals. If you want to retire early, more is always better. If you want to be savvy and smart, and your employer offers a match, then contribute up to the match at least. When you put money away in a 401(k), your money is invested and is able to grow much faster through the magic of compound interest(basically earnin’ interest on top of interest).
So let’s say your company decides to match contributions up to 3% of your salary. You’d want to put away at least 3% of your salary so you get that full match. Basically, you’d have 6% of your salary stashed away with only half the effort. A 401(k) match is part of your benefits package. It’s like “free money” but let’s be real, you work your ass off, so get your employee perks where you can.
Fidelity recommends saving 15% of your pre-tax income each year for retirement. There are limits to your contributions which vary each year. For 2021, the most you can contribute to your 401(k) is $19,500.
So how much you should put away is personal, but maxing out your 401(k) is always a good idea. If that’s not possible, sticking to the 15% rule of thumb or at least getting your full employer match will help you stay on track.