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  • Michael DiBartolomeo

How to Start a 401k

Updated: Dec 15, 2020

Saving for retirement is important. When someone eventually leaves the active workforce, they need money to maintain their lifestyle and upkeep. There are various forms of savings and investment plans that apply to this end, and a 401(k) is a major one. This article breaks down the 401(k)—what it is, how it can be started, and other important details about how it works.

What is a 401K

What Is a 401(k)?

The name of the 401(k) comes from a section of the U.S. Internal Revenue Code. It is a retirement account that employers can offer their employees. There are two distinctive characteristics of this plan—it is tax-advantaged, and it is defined-contribution. Tax-advantaged means that this investment is either tax-free, tax-deferred, or has some other tax benefits.

In a defined-contribution retirement plan like the 401(k), employees contribute a portion of their paychecks to the account. Their contribution may be a percentage or a fixed amount and is automatically deducted from the payroll. The employer, who is the sponsor, may opt to make part or full matching contributions into the investment account. This employer match increases the investment benefits. Defined-contribution plans have restrictions on when and how the employee can withdraw from the account.

How Does a 401(k) Plan Work?

There are two types of 401(k). These are a traditional plan and a Roth 401(k), which is also called a designated Roth account. The key difference between these plans lies in the handling of tax. In the former plan, all withdrawals are taxed as income when an employee withdraws their money, which is usually after retirement. In a Roth 401(k), withdrawals are not taxed. When the employer offers both these accounts as an option, it can also be possible to split the contributions between these accounts, as long as this is within the contribution limits.

The main workings of this retirement plan have been covered—the taxation, the employer matching, and the method of contribution. Another important aspect of a 401(k) is the contribution limit. Employees and employers have a cut off for how much they can contribute to the investment account, and this is adjusted regularly to keep up with inflation. For 2020/2021, there are annual contribution limits of $19,500 for workers under 50 years and a limit of $26,000 for those 50 years and above.

Choosing the 401(k) Investments

Many times, the employee has a say about the investments in their 401(k). They are responsible for selecting these from the basket of options presented by their employer. Some of the more popular investment options include stock and bond mutual funds and target-date funds holding stocks and bonds.

To make an appropriate decision about what to invest in, one must make sure they understand what is offered. After all, if they are to contribute a portion of their paycheck each month per year, they must at least know where their money is going to be used, how the fund is handled, and other things like if they must pay taxes and what the financial merits are of each option. The alternative to investing is saving, but the yields are nowhere near the same. Even with the highest rates, the interest when you save does not come close to the potential earnings using higher-risk opportunities like the stock market. One may want to do some further research and seek professional financial help from investment firms in Pittsburgh PA regarding what they should invest in.

Here are just a few of the step-by-step considerations that must be made when deciding what to invest in:

Understand the basics of the plan to make sure decisions are fact-based.

Figure out what funds one may be able to dedicate to this every month.

Know one's financial position and exact tolerance to risk.

Compare different types of investments.

Make one's pick from the different options.

Increase the funds added to the account over time.

Each of the options to invest in has different risks and expected interest. The stock market is a good choice, but it can take time to learn about which type of business stock is a good choice. ETFs are baskets of stocks on the stock market, and these carry a lower risk than focusing on stocks from a single business. Before opting to fund a stock market opportunity, the pros and cons must be understood.

Can I Start a 401 k on My Own?

Most of this breakdown saving for retirement up to this point has referred to the employer, who is the sponsor, and the employee. Is it possible to set up a solo 401(k) plan? The answer is yes, so self-employed individuals can be their own sponsors and plan for their retirement with this option. When a small business owner, freelancer, independent contractor, or other self-employed person chooses this route, this is known as an individual retirement plan (IRA). A simple IRA is much like a 401(k) in that both the employer and the employees make payments to the fund. Simple is an acronym for Savings Incentive Match Plan for Employees. The simple IRA is thus employer-sponsored like the 401(k).

To get started with a solo 401(k) or IRA as a self-employed person has a few requirements that should be known from the onset. There are also many great advantages of going this route as well. Many freelancers, small business owners, and other self-employed individuals often worry about their retirements because they do not have the same employment benefits that traditionally-employed employees have. Preparing for retirement is important regardless of the nature of one’s work. A self-employed individual has the responsibility of setting this up for themselves, but it is worthwhile and can bring a lot of peace of mind and stability.

To be eligible for an independent 401(k), the individual must be responsible for their income, and they must have earned some that can be verified using tax records. The steps that are required to start up the solo plan include making a written declaration about the retirement plan and whether it is a traditional or a Roth.

The unique benefits of the solo option are worth noting. The most important is the increased annual limits on how much to contribute. When someone sponsors their own 401(k), they are both the employer and the employee, which means that they can use the employer match to contribute in both roles. They can invest monthly as the individual and also make use of employer contributions and their own employer in their own company or business setup. As a result, this solo retirement investment plan's annual limit is double that in a conventional employment setting.

Another important benefit of a solo 401(k) is that the owner has a complete say in what kind it is and what it holds. This added flexibility allows them to choose freely between a traditional and a Roth plan. To do this wisely, they need to explore the tax-benefits and decide which plan offers the most advantageous ones given factors like their earnings, age, and other such considerations. Essentially, solo sponsors get to plan and enjoy their retirement on their own terms.

Finer Details of the IRA

It is worth understanding the difference between a simple IRA and a 401(k) plan, as well as the different types. For someone who is thinking about both options, there are some key things to note. Employers open 401(k) accounts, while individuals open IRAs using a broker or bank. Usually, the former has higher contribution limits, while the latter has more choices for what to invest in.

For employees who are trying to make a decision between either of these plans, they need to focus on whether the company they work for offers a match for the money they invest towards their 401(k) fund or not. When there is a company match, it is recommended that they invest as much money into this fund to obtain the full match. After that, they can think about diverting the rest of the funds they want to save for retirement to an IRA for the rest of the year. It also may be a good idea to look at what happens to your 401(k) when you die.

When the employer does not make matching the funds that the employees contribute, they may want to think about skipping the 401(k) option for the time and going with one of the different types of IRA accounts. Following this path, employees can get access to a greater volume of opportunities to save. In time, if they contribute the maximum allowed during the year in this savings plan, they can choose to fund their 401(k) with the rest of the money. This account has great pre-tax benefits, so this is an option that can help bring higher savings benefits.

IRA plans also come in two versions, depending on how and when the holders of the savings funds must pay taxes. The two options are the traditional and the Roth plan. The limits that one can save into either of these each year for 2020/2021 $6,000 for those under the age of 50 years and $7,000 for those who are aged 50 or older. This is the combined limit on how much money an individual can contribute.

There are other benefits of saving through an IRA. For the traditional fund, amounts contributed can reduce the taxable income in the year they are made if the account is deductible. For the Roth fund, after retirement, the account owner does not pay taxes on qualified withdrawals. Additionally, the money contributed may be withdrawn at any time, and in retirement, there are no required minimum deductions.

Every retirement savings plan has its pros and cons. The cons for an IRA fund include lower contribution limits than the 401(k). The Roth does not offer any immediate tax benefits from contributing money to it. At higher incomes, the ability to contribute to it is also phased out. In the traditional funds, when the individual or their spouse have a workplace retirement account or have higher incomes, the deductions are phased out. Distributions in retirement also incur income tax like other normal income. Starting at the age of 72, there are also minimum distributions.

How Much Money is Needed to Start a 401K

How Much Money Do You Need to Start a 401 K?

Not that the basics of starting an independent 401(k) has been covered, another question arises on the amount of money required to begin. The requirements for setting up the account have been explained—being responsible for one’s own income and having earned taxable income. The upper limits for an annual contribution to the plan have also been covered. Deciding how much to contribute each year is a major decision. It is important to understand the details of what funds can be added.

There is no minimum amount of money that must be contributed to the plan. That is good news because it opens up the benefits of this retirement account for self-employed individuals who have limits on how much of their income they can set aside for retirement.

For those that have more freedom in how much money they can regularly set aside, there are some recommended annual contributions. Finance experts have calculated recommendations on how much money one should have in their retirement plans at different ages and all based on the current salary.

Others suggest 6-10% of monthly income as a good amount to contribute to a retirement savings plan. Following either of these methods leads to a comfortable expected retirement amount by the time the person retires. Ultimately, the method to use to determine one’s ideal retirement contributions is a personal choice. Current income and existing financial responsibilities must both be taken into consideration. In the end, what matters most is that some money is being set aside consistently into a retirement account.

Can You Start a 401k Anytime?

It's always better late than never to begin saving for retirement. Every amount invested can yield some benefit, but when nothing is invested, there can be no benefit. The key advantage of starting as soon as possible is the compounding interest over the decades before retirement.

For individuals who have entered the workforce straight after college or had more conventional employment experiences, there are many calculations to guide on how much money should be saved up by what age. All the groundwork and information required to begin planning for retirement is presented to them by the employer, and it is for them to select which of the options they want to take.

For those who are self-employed or following other employment journeys, more work and research is required in setting up a solo retirement account. The IRS has guidelines on how much can go into a 401(k) for those under the age of 50 years and those 50 years and older. As long as someone is still self or company employed, they can continue making contributions towards their 401(k) plans until they retire. Many people are opting to stay employed longer and beyond the 50-70 years period. Those who are past the age of 70 ½ years and are still working can continue to make contributions to their retirement accounts. There are tax savings opportunities available in such cases.

As far as what time of the year to begin, the IRS has rules about which contributions can be made for which tax year. The cut off for setting up the solo plan is the last day of December in the tax year for which contributions are being made.

Other Pension Schemes

There are many other options for retirement plans. Each of these offers something slightly different. One of these is a traditional pension. In this example of a defined-benefit plan, the employer awards the employee with a specific cash benefit amount when they retire. Over time, this pension method has dwindled in popularity, as the 401(k) has gained. In the latter, the risk and responsibility of retirement savings lie more heavily on the employee than in the former alternative.

There is a need to evaluate a lot of information when planning and saving for one's retirement and make sure these are understood. One can get the maximum benefits and save the most by exploring all options and seeking sound financial advice. Starting a 401(k) is possible, whether as employees in an employer-initiated and sponsored alternative or as a self-sponsored IRA through a bank or broker. By comparing requirements on how much one can contribute, the handling of tax dollars, distributions of funds, and other conditions, one can get the suitable option for their age, income bracket, and employment category. Starting to save for one's post-employment time is most appropriate as soon as possible; one does not need many funds. Every small bit of savings can help in the long-term.

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