How to Use a 401(k) to Reach Your Financial Goals

Understanding your 401(k) basics can help you make the most of your plan.
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Definition:

A traditional 401(k) is an investment plan that is offered through your employer. Once you are eligible to contribute to a 401(k) (some companies have a waiting period) you will be asked to sign up to contribute a certain amount each month. Generally, this is a percentage of your income. Your employer may offer to ​contribute matching funds up to a certain percentage. It is possible to max out your allowable 401(k) contributions.

It is important to understand the 401(k) basics so you can take full advantage of it.

Once you begin contributing to your 401(k), you will be asked to distribute your funds into different types of investment funds. When you are in your twenties, you will want to put the majority of your funds into the high-risk high growth group. You will make money by leaving your money in these funds over the long-term even though they may go down at times. You can distribute the remainder of your funds in medium risk and low-risk funds. As you grow closer to retirement you will want to change this so that you have the majority of your funds in the low-risk funds.

Traditional 401(k) contributions are made with pretax dollars. This can lower the amount of income tax that you pay on your salary now. However, you will be taxed on your withdrawals when you retire. You may want to consider using a Roth 401(k) as well, these contributions are taxed when you make them, but you are not taxed on your withdrawals.

The Roth option will reduce the amount of taxes you pay over your life time. If you do have this option, it will benefit you to pay the taxes instead of waiting and paying them when you retire.

You should track your 401(k) account. You do not want to have the majority of your money invested in one single stock or in your company stock.

This is risky, because if it were to fail you could lose the majority of your retirement savings. It is important to diversify your funds. You should receive a report of your 401(k) balance and earnings at least once a year. The report varies from company to company. It should include your beginning balance, your contributions, and your ending balance. You need to make sure that your contributions are being credited correctly.

Once you begin investing in your 401(k), you should leave it alone. You may be tempted to take an early disbursement of the funds or to take out a 401(k) loan. However, you will face taxes and penalties on the disbursement and there are strict rules surrounding the loan. You may be shortchanging your retirement years by dipping into the money now. If you change employers, you can roll your 401(k) over into an IRA, which may give you more control over how the money is invested. It is important to monitor your 401(k), but you should not panic as the amount fluctuates with the market.

If you are self-employed or you are a stay-at-home parent, there are alternative retirement savings options available to you like self-employed retirement accounts or the spousal IRA.

If you have a waiting period for your 401(k), you can still begin contributing an IRA right away so that you are still saving for your retirement. This will help you start saving and make it habit to continue to save as your job changes.