When it’s your time to retire, don’t expect social security to pay all the bills. In fact, according to the Employee Benefit Research Institute (EBRI), on average, social security accounts for just 40% of the income needs of persons 65 and over. The majority of retirees rely heavily on earnings from pension payments from employers and from personal retirement plans or other personal investments and earned income. In essence, the onus is on you to fund your retirement.
One way to start saving for your golden years is by contributing to your employer’s 401(k) program. Young people who have longer time horizons until they retire often put this off, but time is a powerful ally for a young investor. “The more you put aside now, the more the markets will work for you over your lifetime,” explains Bob Carlson, editor of the monthly newsletter, Retirement Watch. Below is a quick guide to get you up to speed on how your 401(k) works and how you can invest smarter in your workplace savings plan.
Unlike most other saving programs, a 401(k) plan allows you to make pre-tax contributions—your contributions are deducted from your pay before taxes are calculated. Carlson breaks it down.
Enroll: At enrollment you will set a contribution amount subject to IRS limits and decide how much you want to invest.
Make contributions: Your employer will automatically deduct the contribution you agreed upon every pay period from your paycheck before taxes. Those monies are withheld and deposited into your account.
Employer matching program: If your employer matches your contributions and you’ve met its eligibility requirements, your employer will also make contributions to that account. “The typical employer-matching formula is 50 cents on the dollar,” says Carlson. For example, for every dollar you contribute, your employer contributes 50 cents for a total contribution of $1.50. “This is basically free money.”
Invest: Your pre-taxed contribution and your employer’s contributions are then invested into the investment options you selected (see Asset Allocation next week). Your savings will compound and you will earn dividends.
Retire: When you meet retirement age (65-years-old) you can withdraw your funds. These savings will now be considered income, and taxes will be due on your distributions as you take the funds out.
Check back next week for Asset Allocation 101.