A 401(k) — which gets its dumbass name from the tax code that governs it — is an employer-based retirement savings plan. 401(k)s allow you to save and invest a portion of your paycheck pretax. Having this money deducted from your paycheck pre-taxes is vital because it lowers the amount of your taxable income. If your paycheck is usually $2,000, but you decide to contribute 10% to your 401(k), only $1,800 of your paycheck is taxable.
Unlike a regular ol’ savings account where money is usually sitting around with interest rates lower than midget limbo, the money that’s in your 401(k) is meant to be invested. You can't just go to your 401(k) and pick out the stocks you want, though. Your employer will provide you with a set amount of investment options you can choose from (usually different funds and company stock). Here’s where it gets a little tricky for most people. After all, if everything were smooth sailing, I wouldn’t be writing this blog at midnight on a Saturday; I’d be on Snapchat standing shirtless in the club, grinding my shoes into couches like Rick James.
Working and getting the money for your 401(k) is one thing; knowing how to divide that money between investments is a whole ‘nother ballgame. There’s no one-method-fits-all approach when it comes to this, but here are some things to take into consideration when deciding how to allocate your money:
1. Risks. You must come to terms with the fact that there will be risks involved anytime you’re investing, and you must be able to gauge your risk tolerance. Stocks are the riskier investment choice, but they have an opportunity for higher returns. Bonds, on the other hand, are a safer choice, but their returns aren’t quite as appealing. But, just like I wouldn’t advise you to let the local crackhead borrow your car and expect good things to happen, I wouldn’t recommend you to put all your money into one investment and expect good things to happen.
2. Allocation. Younger folks who still have decades left to save for retirement should look to take more risks in their younger years. However — as your hairline starts to recede, as it starts taking you three days to bounce back after a night of partying, and as you begin accidentally calling your kids by their siblings’ names — you should start transitioning to a portfolio with fewer risks. This means a stock-heavy 401(k) early on that gradually decreases the number of stocks and increases the number of bonds owned as time goes on.
A rule of thumb is to take your age, subtract it from 110 , and put that percentage into stocks. For example, if you’re 25-years-old, your 401(k) should be roughly 85% stocks using this method.
3. Just how much to contribute? I’m here to apologize If you thought you’d get a clear answer to this question. As with many (if not all) things personal finance related, it’s relative to the person and their respective situation. Companies will often match a certain percentage of what you contribute to your 401(k). At a bare minimum, you should contribute whatever that percentage is. If you contribute less than what your company matches, then you’re as foolish as the man who asks a woman what she wants to eat and expects a straightforward answer. It’s literally like turning down free money.
Below are some things to take into consideration:
- The max you can contribute to your 401(k) annually is $19,000. If you’re 50 or older, this amount becomes $25,000. Your employer’s match is not included in this amount.
- Set your 401(k) percentage to your employer’s match and then focus on setting aside an “emergency fund” (six months worth of living expenses) in a standard savings account. If life ever comes at you fast and you need access to emergency funds, it’ll be 10x easier (and cheaper) to get it from a savings account than it would be dealing with the hassle and penalties associated with withdrawing early from your 401(k). Once you have an emergency fund saved, raise your contribution.
- If you’re in debt, your focus should be on lowering your debt versus maxing out your 401(k) contributions. Debt comes with interest, so make it a priority. The longer it sits around, the more expensive it gets. If you’re still relatively young, don’t try and save a ton for retirement at the expense of staying in debt. That’s...not smart.
- Challenge yourself to increase your contributions by 1% each year until you’re contributing 15%. Don’t go on a crackers and tap water diet to try and accomplish this, but it's definitely something good to work towards.
What happens if you need to withdraw from your 401(k)?
If you’re younger than 59½-years-old and choose to withdraw money from your 401(k), it will be subject to income tax and a 10% penalty tax. Depending on the amount, you could end up with as little as half of what you withdrew. The game is foul, dawg.
If you’re 59½ or older, the money you withdraw from your 401(k) won't be penalized, but it will still be subject to income tax. So instead of paying Uncle Sam on the frontend, you pay the taxes on the backend. You should’ve known tax-free [legal] money was too good to be true.
Can you borrow money from your 401(k)?
It is possible to borrow money from your 401(k), but when you borrow the money, don’t think you’re just transferring money from one account to another. Nahhh, fam. There’s always a catch. Even though it’s your money, you’ll be responsible for paying back the loan amount to yourself with interest. If you’re employed, the payments will be taken directly out of your paycheck every month like child support; and even though you make contributions pretax, repayments are taken out after taxes. If you can’t repay this loan, it will be treated as a withdrawal, and the above-mentioned taxes and fees will then apply. The max you can borrow is either $50,000 or 50% of what you contributed. Whichever is less.
401(k)’s aren’t the easiest things to comprehend, especially with a lot of aspects being relative to a person’s situation. Trust me; I get it. Because of this, I'm always willing to help out and provide some advice and feedback. Email me, text me, call me, tweet me, or send a pigeon with a letter attached to it. Whatever means you choose, I encourage you to reach out and get your questions answered. That’s why I’m here. In the meantime, remember to drink more water, support local businesses and laugh a lil’ bit.