Do you remember the first job you had that had a deduction from your paycheck for a 401(k)? For most people, this is their first introduction to investing, and most of the time they don’t understand where that money is going or exactly what is happening. All they know is that when they retire they will be able to live off of those funds. Some people will even start to increase their contributions to their 401(k) as they make more money in the hopes that it will help them retire earlier or to be able to live more lavishly when they do retire. We are going to discuss what exactly a 401(k) is and if there is a better option to investing than just bumping up your 401(k) contributions.
What is a 401(k)?
A typical 401(k) is a retirement account that you contribute pre-tax dollars to. This means you do not pay taxes on the contributions made to your 401(k). Most employers also have some kind of “match” where they will also contribute to this fund as you do. This match varies between companies, but a 5% match is common. That means if you contribute 5% of your paycheck to a 401(k), then your employer will contribute the same amount in addition. If you contribute more than your company matches you will just put more of your paycheck toward your 401(k) with your employer’s contribution still only matching the 5%.
401(k)s can have a few different investment options but typically will have some sort of “target fund” investment. This is a fund that is designed with a retirement date closest to when you plan on retiring. The fund will change as you get closer to retirement age. Now the thing about 401(k)s are since you contributed pre-tax dollars, you must pay taxes when you go to withdraw the funds. Once you retire and start taking money out of your 401(k), the government will tax that as ordinary income. This can eat away large portions of your retirement account. This doesn’t mean that a 401(k) is a bad option, but it does mean that you shouldn’t “put all your eggs in one
basket” and should have an order of operations to where you put your investment income. What percentage should you put into a 401(k)?
Milestones
There are several milestones you should aim to achieve when it comes to how you invest your money. The first milestone should be to increase your 401(k) contributions to whatever your employer match is. For example, if your employer matches 5% then you should aim to get to 5% and then stop. This allows you to maximize any free money your employer gives you. But what if you have more money that you can put towards savings? Where should it go?
Safety Net
You should make sure that you have enough in savings to cover a few months worth of bills. Some say you should have up to 6 months’ worth, but it is up to you. You should have enough in your checking and savings account where you wouldn’t need to tap into any other accounts such as your retirement accounts.
ESPP
Now that you have a safety net set up, it’s time to decide where to put some more funds. Now this option may not apply to everyone but if your employer offers any sort of ESPP or Employee Stock Purchase Plan, you should start contributing here. Typically these plans allow you to purchase discounted stock. Depending on the rules of your company plan, you should aim to maximize what they allow you to purchase. There are usually waiting periods for these types of plans, but this is usually a safe bet. Whether you decide to hold your company’s stock or sell right away is up to you, but it is smart not to miss out on these plans if they are available.
Roth IRA
At this point, you have your 401(k) contributions set to your company match, you have a safety net you feel comfortable with, and you are maximizing your company’s ESPP if available. From here if you still have additional funds you want to invest you should consider a Roth IRA. This is an Individual Retirement Account like a 401(k) but with a major difference. You contribute to this fund using after-tax dollars instead of pre-tax dollars like a 401(k). While this may not be great news right now, it is a huge benefit when you retire since you will be able to withdraw the funds tax-free if you meet the requirements. Roth IRAs do have contribution limits so your next milestone should be to contribute the max every year. As of 2024, the limit is $7,000, but the maximum usually incrementally increases each year.
What Now?
If you have followed the orders of operations listed here and have just maxed out your yearly Roth IRA contributions and are wondering where you should put some additional funds, well congratulations! You have set yourself up for a great retirement and are on your way to financial freedom. From here you can decide where you want to put any extra funds you want to invest. Perhaps you could increase your 401(k) contributions past your employer match. Maybe you can put some funds into an investment account and try trading stocks. Maybe you could increase that safety net of yours. There is no wrong option at this point. The biggest thing is that you do these investments before doing something else. This helps you take advantage of the most impactful investment options with the funds you have available.
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