A 401(k) is an account used to save for retirement which is set up through one’s employer. The name 401k comes from the Internal Revenue Code section by the same name. It was originally introduced in legislation in 1979.
A primary benefit of the account is that it offers the individual the ability to invest in mutual funds, individual stocks, bonds, money market accounts, and more utilizing pre-tax dollars. For example, if the individual made $1000 on a paycheck and was taxed at a 20% rate, $200 would go towards tax. If however he or she put $100 of the paycheck in a 401(k) account, that $100 would not be taxed leaving only $900 taxable with $180 paid in tax. The investment will grow untouched by tax until it is withdrawn for retirement.
Many employers include a certain match percentage so that if the individual contributes 6%, they may contribute an additional 3% to encourage you to save for retirement. This is an automatic return on the investment and should be taken advantage of when at all possible.
As far as selecting mutual funds within a 401(k) account, one should take into account how many years till retirement they have as well as their present age. A younger person in their 20s may want to use a more aggressive growth strategy by investing in high growth mutual funds as well as international or small cap funds. These tend to be more risky but also have high potential for growth.
A person closer to retirement in their late 50s or 60s will likely want to begin investing in more stable types of investments such as growth & income or value mutual funds as well as blue chip (big, established companies) funds. These tend to be more conservative while still pursuing modest gains.
Regardless, of the person’s age, he or she should spread investments among multiple funds to further diversify risk and have access to multiple market growth segments.
A good resource for identifying good mutual funds is www.morningstar.com. They provide in depth information on the performance of a fund over a long period of time.
Another factor to consider in choosing mutual funds for your 401(k) is the expense percentage of the fund. There is some cost involved in managing and running a fund and this is taken out of the overall profits. So if a fund charges a 2% expense fee and it gains 10% in a year, the realized return for the investor would only be 8%. One should seek out lower expense fee funds or even consider an index fund which has the lowest expense ratio of all. This low expense ratio is because the fund matches and index such as the S&P 500 as opposed to a fund actively managed by a professional manager.
It should be noted that under current rules, money cannot be withdrawn from a 401(k) without significant penalties and tax implications until age 59 1/2.
If you would like for someone to sit down with you and help further explain mutual funds and pick some with good long term track records, you can seek out a Certified Financial Planner. You may also choose to consult with a financial counselor to discuss other parts of your finances. Local financial counselors can be found at http://www.daveramsey.com/sa/mutualfunds/. These professionals should have the heart of a teacher and help to explain everything in easy to understand terms.
An additional retirement account to consider is a Roth IRA. These valuable retirement vehicles differ from a 401(k) in that they are funded by after tax dollars but are not taxed at all when the money is withdrawn at retirement.
A little invested from each paycheck into retirement will grow greatly over time and provide a financially peaceful and comfortable life in later years.