Should I invest in 401k? What is a 401K
401K is a retirement account that your company sponsors and as an employee, you can contribute. Some companies match up to a certain dollar amount. First off if the company matches, make sure you are maximizing their contributions, after all, it’s free money. So now the question is how much should you contribute. Well number one, only contribute if they “Match” and secondly, contribute only what they’ll match. “Matching” means the employer will put in money as long as the employee puts in money. Usually determined by a percentage. For example: if the employer states it will contribute (match) up to 5% and you make $30,000 a year, and you as the employee puts in the 5% or $1,500, the employer will put in $1,500. It is essentially additional free money from the company you work for.
What is vested?
This means ownership. As an employee, the ownership of the money your company contributed to your 401K. It is the money your company can not take back. Usually set by a certain % and time frame.
Example: (Fully vested) You make $30,000 a year, the company matches 5% ($1,500) so you put in the 5% ($1,500) a year and are 100% vested as soon as you contribute. In this scenario, the company does not own any of the contributions they made. So you quit your job after 2 years the $3,000 ($1,500 x 2 years) you put in plus the $3,000 the company put in is your money, so you walk away with $6,000
Example: (Cliff vesting) You make $30,000 a year, the company matches 5% ($1,500) so you put in the 5% ($1,500) and it will be 100% vested in 3 years. So if you quit the company before the 3 years you will not get the company’s contribution. If you quit after 2 years, you would have contributed a total of $3,000 in this account and the company would have contributed $3,000, you will only be entitled to the $3,000 you contributed. Now if you wait until the 3 years then you would walk away with the whole amount.
Example:(Graded vesting) You make $30,000 a year, the company matches 5% ($1,500) so you put in the 5% ($1,500) and it will be 100% vested in 4 years, vesting 25% per year. If you quit after 2 years, you would have contributed a total of $3,000 in this account and the company would have contributed $3,000, according to the vesting schedule you are 50% vested (25% per year x 2 years) So you will walk away with the $3,000 you invested and $1,500 (50% of $3,000) of the companies contribution, a total of $4,500
There are other retirement accounts such as Traditional IRA or Roth IRA. These have a lot more flexibility as far as investment options go. Typically 401K is limited to mutual funds only. In either IRA accounts, you could invest in mutual funds as well but it doesn’t stop there you could invest in stocks, bonds, ETF, annuities, CD, money market, and even real estate.
What to do after you quit? Should I still invest in 401k?
You have several options. Roll it over to your new jobs 401K, cash out, leave it, or roll it into another retirement account such as an IRA.
Rolling it over to another 401K. You still have a minimal amount of choices to invest in since there are only mutual funds. You will not be penalized or taxed.
Cash-out. Not recommended, since they penalize you for taking the money out before retirement which is 10% if you’re under 59½. Then they take out taxes as a normal income tax. Depending on your tax bracket you could lose about a ⅓ or more.
Leaving it in your old company’s 401K. There is no harm in this but, you will not be able to contribute or do anything with it. A recommendation will be rolling it into something.
Rolling it into an IRA account. There are several types of IRA accounts that you could contribute to. 2 major ones are Traditional IRA and Roth IRA. The biggest difference between the 2 is how they are taxed. In a Traditional IRA, you do not pay taxes when you contribute, you will pay when you withdraw from the account according to the tax rate at the time of withdrawal. Roth IRA you pay taxes upfront, if you anticipate tax rates to go up when you retire this will be the one to choose. We will go further into the IRA in another article.