The year 2020 has been difficult for everyone. Some people have been fortunate enough to keep their jobs and health and we should be thankful for that. With the tremendous detriment to the economy, and the easing rules of withdrawal from 401k/retirement accounts, you might be making some mistakes. I will talk about some mistakes you might make with your 401k account.
What is a 401k?
Let’s first talk about what a 401k is. When you sign that offer letter from your employer, they provide you certain benefits. If you’re fresh out of college, you would usually brush aside the stacks of papers they give you explaining what these benefits are. However, those benefits are very important to learn about and get familiar with. One of these benefits is the 401k/retirement account.
A 401k/retirement account lets you save money for your future. The money you contribute to this account is tax deductible, meaning you can deduct your contributions from your taxable income at the end of the year to a maximum of about $19,500 as of 2020. This means you are not paying taxes upfront on that portion of your income, but deferring them to a later date when you withdraw from it. Usually employers would offer you a certain company match contribution. So if you were to put 5%, they would offer to match your contribution up to 5%. This means that you are getting 5% of free money and increasing your total stashed amount to 10% of your salary!
Once you get those stack of papers (or PDFs) about your benefits, make sure you find out the funds offered by your 401k provider. Make sure you call your provider (could be Vanguard, Schwab etc.) and create an account for your own personal access. Keep in mind that the returns that you get on this account are all tax free. So if you were to buy a fund for $10 and its value became $20 after a few months, you don’t have to pay tax on this increase even if you decide to sell this particular investment. So with respect to capital gains, this is truly a tax free account.
The caveat to this great account is that you can only withdraw from it after you reach the age of 59.5 (except in some cases). Also, since you didn’t pay tax upfront, you will have to pay regular income tax on any withdrawals you make from this account.