Since this has been one of my most requested video topics, I’ll be discussing exactly what a 401k is, why you should (or shouldn’t) contribute to it, and several of the pros/cons of this retirement account. While it does allow you to invest up to $18,000 per year of pre-tax money, reducing your taxable income and potentially saving you thousands, it may come at a cost depending on your situation and it’s important to take everything into consideration. Feel free to add me on snapchat / Instagram: GPStephan
What does a 401k do: It allows you to invest with pre-tax money so you have a larger amount upfront to invest with. You can contribute up to $18,000 per year to this account, or $24,000 per year if you’re over the age of 50. The way it works is pretty straight forward - the money you contribute to a 401k is not taxed right now, but instead it’s taxed when you reach retirement age of 59.5 - when hopefully you’re in a lower tax bracket than you are right now, so you end up profiting the difference from what you would’ve paid in taxes NOW, and the lower rate in the future (hopefully).
The biggest advantage here is that you have pre-tax money working for you. That $4500 you would’ve paid, for instance, can be invested and grow to a substantial amount when you’re much older.
If you’re employed right now, you can check and see if your employer has a 401k plan - if they do, speak with your employer and go ahead and you can begin contributing to it. Sometimes your employer will offer you a FREE match up to a certain amount - this is pretty much just free money, so you should go ahead and contribute up to the match.
If you’re self employed, you have the benefit of opening up a SEP / SOLO 401K - this is a 401k plan that you can contribute to as both the employer and the employee, allowing you to contribute up to $54,000 of income.
If you’re not employed, don’t worry about it - but consider making some money and opening up the IRA account.
Generally speaking, a 401k makes the most sense if you’re making a lot of money right now and intend to retire in a lower tax bracket. This means you pay less taxes right now, and then when you retire in a lower tax bracket, you profit the difference from what you pay today and the lower amount you’ll pay in the future. You also have MUCH more money working for you right off the bat than if you went with a Roth account, which is done with after-tax money. But chances are, if you’re young and expect to continue to earn a lot more money into the future and in retirement, do your research most likely a Roth IRA is going to be a slightly better choice.
However, unlike a Roth IRA where you can withdraw your contributions without penalty…in a 401k, you must leave your money in there. If you take it out, it’s subject to taxes and a 10% penalty unless under specific circumstance - so I recommend just leaving it in there.
Now, lets discuss a few downsides I personally see with the 401k option.
1. Lack of liquidity. You tie up your money long term.
2. Your employer plan could have really high fees. Seriously, if your employer has a plan that charges something like 2% per year, that could dramatically reduce your returns.
3. There’s a chance you retire in a higher tax bracket. That’s one of my biggest worries for myself personally, is that even though I’m earning a lot right now, I have no intention of this decreasing during retirement - I actually want to make more money when I retire.
4. Your money is subject to market risk. This is pretty much unavoidable, but there is risk - and i’ll cover this risk in future videos.
Personally, I recommend doing a little bit of everything - I have a Roth IRA account and a 401k, so I contribute to both just to give me more options. No one really knows what the future will hold and what taxes will be like in 40 years, so doing a little bit of both hedges your bet and gives you a bit of a safety net. With this said, this video is just meant to be an introduction to a 401k and its options so you could continue to do your research and determine what’s right for you!
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