Updated: Feb 20
I enjoy working with young adults who are starting their careers. From my years of experience, I know that the key to financial success is learning early on how investments work and how to best utilize the money you earn. Many young adults begin their careers in large companies that offer 401(k) programs. 401(k)s are basically retirement plans that are tax-deferred and to which the employer contributes a certain amount each year. In most cases, employees may also contribute to their 401(k) and the employer usually matches this amount with their own contributions.
While 401(k)s are not that complex once you become familiar with them, many young people have questions when they first encounter these types of plans. Here are three of the most common questions about 401(k)s and the advice I give.
What’s the Best Way to Contribute to my 401(k)?
When you’re first starting out, you may find it tough to take a portion of your paycheck and invest in your 401(k). If you’ve successfully avoided peer pressure and not gone into serious debt with student loans and a big mortgage, you should have enough to contribute each month without hurting your lifestyle. However, if you really don’t think you can spare it, try this easy trick: change your tax withholdings. With a 401(k), if you contribute, say $100 a month, you won’t actually get $100 taken out of your paycheck as it will be taken out of your paycheck before it’s taxed. So say it amounts to about $80 per month that’s being taken out. If you adjust your tax withholdings to how many you claim, you can probably add that much to your check each month and it evens out. You’re simply shifting that money from your tax pocket to your investment pocket.
When Does my 401(k) Get Taxed?
As we talked about in my blog about when certain types of investments get taxed, some investments get taxed when you put money in, some get taxed when you take the money out, and some very special investments never get taxed at all. Depending on your situation and what you plan to do with the money you are investing, the way the investment is taxed can have a big impact on your goals.
401(k)s are one of the investments that are taxed when the money is taken out rather than when it’s invested. What does this mean for you? It means that your tax situation now doesn’t matter when it comes to contributing to your 401(k). Your tax situation will matter, however, when you take the money out and this could take a big bite out of your money. That’s why I always encourage my young clients to stay flexible and diversify when it comes to their savings and investments.
Should I Cash Out My 401(k) When I Change My Job?
Though most young adults won’t face this for a while, most will eventually change jobs and wonder what they should do with their 401(k) from a previous employer. I often get asked if they should just cash it out, and the answer is almost always ‘no!’. If you cash out your 401(k) before you turn 59 ½, not only will you pay taxes on the full amount, but you’ll also pay a 10% penalty. The better option is to roll it over to an IRA, or an Individual Retirement Account. You won’t lose your money or have to pay any penalties or taxes and you’ll own that account. While you’ll no longer have the employer contribution component, you can continue to contribute to the plan and possibly roll it over again when you secure a new job.
401(k)s are valuable part of any young adult’s retirement planning. If your employer offers one, I encourage you to contribute and take advantage. Just be aware of the above information.
And, as always, if you have any more questions about 401(k)s, please leave them below and I’ll be happy to answer them!