How Does a 401(k) Grow
A 401k is a type of retirement account that lets your capital grow tax-free. A 401k typically holds various assets including stocks, bonds, mutual funds, and more. Similarly to how stocks grow, your 401k will grow in the same fashion.
Like almost any investment, your 401k will not grow significantly overnight. It will take time and patience to get the most out of your money. Historically the stock market will return around 7%-10% annually. Because of this, and penalties, if you don’t, you should plan to leave your money in your 401k until you are at least 59 1/2 (we'll get to this more below).
In this post, I'll explore how a 401k grows and what types of investments your 401k contains. Let's get started!
Types of Investments in your 401k
Like we mentioned earlier, your 401k can include many different types of investments. The most common are stocks, mutual funds, ETFs, and bonds.
Types of Growth
Your investments can grow one of two ways. They can increase in value or they can provide cash payments. Many investments will offer a combination of the two.
Increase in value
As your investments produce income, their value will increase. People will be willing to pay more for an investment with routine growth. Think of a stock such as Lululemon. While Lululemon doesn’t pay high dividends, it has increased in value significantly over the past few years because of its perceived value and growth potential.
The other way for your 401k to grow is through dividends or cash payments of a companies profits. In short, whenever a company makes a profit, it can choose to reinvest them in the company or pay them out to investors. Usually, it is a combination of the two.
Some companies, namely utility companies, will pay higher dividends as their market may be saturated and room for growth is limited.
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Some companies offer a 401k match typically capped at a percentage of your income. It is always wise to take advantage of this as it is FREE money. Even better, tax-free, free money.
When companies offer a 401k match, sometimes it will have vesting guidelines to encourage you to stay longer at the company. Think of vesting as your ownership of your 401k. For example, some companies may require you to stay at the company for 5 years to be fully vested. Meaning after 5 years, you may leave at any time and own 100% of your 401k balance. If you leave before 5 years, you may not own 100% of the balance. The terms should be outlined in your plan agreement.
Related: Types of Income
The main way that your 401k will grow is through compounding interest. In simple terms, compounding interest is interest on your interest.
For example, if you are averaging a 10% return on your investment annually, after three years your investment would have grown 33%. Notice how it’s not just 30%. This is because of compounding interest. Compounding interest is the fastest way to accumulate wealth and your 401k will do that.
When you start investing in your 401k, you’ll need to determine your risk tolerance. Those early on in their saving can select a more aggressive strategy while those nearing retirement should elect for a more conservative strategy.
Withdrawing early from your 401k will bring about potentially costly penalties. As of 2019, you can withdraw money from your 401k penalty-free after the age of 59 1/2. Currently, for withdrawing early you will have to pay a 10% penalty plus income tax on your withdraw. This amount is determined by your income tax bracket. You can find your income tax bracket here. This can add up significantly, especially if you are in a higher tax bracket so it is wise to leave your money in your 401k account until after the age of 59 1/2. There are some exceptions to the age requirement, however.
You are allowed to withdraw money from your 401k account penalty-free if you move it into a different 401k account within 60 days.
Your money may be distributed tax-free to your beneficiaries in the case of death.
If you become disabled, you can withdraw from your 401k penalty-free. This will require documentation from a licensed physician.
You may withdraw from your 401k penalty-free to pay medical expenses if they exceed 10% of your AGI.
As tax law changes quite frequently, we always recommend consulting a tax professional before making any withdraws to avoid potential tax liabilities.
The IRS caps the amount you can contribute tax-free to your 401k account. In 2019, this amount is $19,000 for the year. This amount is revised annually. If you are older than 50, you may contribute an additional $6,000 (2019) per year to help grow your retirement account before you retire.
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What to do once I’ve reached my cap?
If you have capped out your 401k account and still want to invest in your retirement, your next best option is a Roth IRA account. You can contribute your taxed income and let it grow tax-free. Unfortunately, IRAs are also capped. In 2019, this amount is $6,000 annually or $7,000 if over the age of 50.
Final Thoughts on How Does a 401k Grow
401k’s are the best way to accumulate wealth and allow your hard-earned money to grow tax-free. Whether you’ve just started your career or are nearing retirement, contributing to a 401k account is a no brainer that you can’t afford to skip out on.