The power Of The Retirement Accounts
401K Retirement Accounts Guide
My parents taught me about saving money and the importance of saving from a very young age. Saving for my parents and what they knew is saving cash in a checking account or under the mattress (a classic Middle Eastern way) … Guess what would happen after 10 years, the money loses its value due to inflation... Therefore, I wasn’t a fan of saving until I hit 30.
In 2019, I started to pay attention to my finance and educated myself, and OMG! I got obsessed; I regretted every single day in my 20s for not teaching myself about personal finance and investment. I learned that there are many ways to save money besides having cash sitting in checking accounts. You can save and double your saving with many investment options. The 401K account is one of them and this is what I will be focusing on today.
This post may help my fellow immigrants to get their finances together and build wealth in their retirements. As an immigrant myself, it wasn’t easy to understand the US retirement system. After educating myself and learning a lot, I want to share the knowledge I acquired and how to plan better for our old selves.
Disclaimer: This post is not intended as investment advice. It is more for education purposes, and I do hope it answers some of your questions about 401K, saving, and investing
Index
What is the 401K retirement Account?
How does the 401K retirement account work?
Example
What is Compound Interest
401K retirement account benefits
What is Roth 401K?
Are the retirement account and the compound interest Halal?
What is The 401K Retirement Account?
The 401K is an employer-sponsored retirement account that is popular in the United States. It is usually offered by employers to their full-time employees. Some companies offer matches (technically free money) if you contribute to the 401K retirement account. The money will be available to withdraw at age 59 and ½. You can withdraw before that age, but you will pay an early withdrawal penalty
How does the 401K Retirement Account work?
The idea of an employer retirement account is very simple. Every paycheck, you contribute a certain percentage from your paycheck to the 401K account as saving for your retirement. The account is tax-deferred; the contributed amount is taken pre-tax, and it gets deducted automatically from your paycheck. Then, the money will be invested in the investment funds that were selected by you. Over the years, the money in the account will grow and start working for you. The earlier you start, the better.
You need first to enroll in a retirement account and pick your investment fund, and contribution percentage.
Example
This is a hypothetical example:
Scenario: Sam is a full-time employee at Yazy Journey. Sam gets paid bi-weekly. Her pre-tax paycheck is $1,000.
Employer offer: Yazy Journey offers a 401K retirement plan through Fidelity for all the full-time employees with up to a 4% match. The investment funds that Yazy Journey offers to their employees in the retirement account are target funds
Target Fund: It is a mutual fund and is designed to help manage the risk of investment. The closer the participant in the target fund gets to the retirement age, the less risker the target fund gets. The fund changes the investment option within the fund from aggressive (stocks) to conservative (bonds)
401K contribution: Sam contributes 4% of her salary
Investment funds selection and allocation: Sam picked fidelity target fund 2060 (she thinks she will retire in 2062) and allocated 100% of the contribution to go that investment fund selection
Since Sam gets paid $,1000 bi-weekly, that means $40 goes every two weeks to her fidelity 401K account and the money gets invested into the Fidelity Target fund 2060 that she picked. Also, Yazy Journey will put another $40 every two weeks into Sam’s retirement account and the money gets invested in the same fund.
What does that mean?
For a full year, Sam invested $2080 (her contribution is 1040 and the employer matched her contribution) into the Fidelity target fund 2060. Let’s say the average rate of return (ROR) of the fidelity target fund 2060 is 10%
Year 1 —> Invested $2080 —> ROR 10%—> earned $208 as an investment gain —> total invested after 1 year is $2288
Year 2 —> Invested $2080 plus $2288 from last year —> ROR 10% earned $436.8 as an investment gain —> total invested after 2 years is $4804
The longer Sam is investing and the more she is putting, the more she will earn from her investment… thanks to the compound interest.
What is the Compound Interest You May Ask?
Your investments will pay dividends (gain); when the dividends get reinvested, it will make more dividends as well and this is the meaning of Compound Interest. It simply gains from gains and it compounds over time… It starts with a small amount but gets bigger with time and it accelerates the growth substantially.
So, let’s say Sam stopped investing in the retirement account after year 2. Her principle is now at $4804
Using the compound interest formula, we can calculate how much the money will grow in 10 years:
Accumulated amount after 10 years = Principle (1 + [annual return rate / number of times the interest compound per year (n)]) ^ n*number of years
Amount $ after 10 years: $4808(1+(0.1/12)) ^ 12*10 à $4,808 (1.008) ^120 —> $ 4,808 *2.601 —> $12,505.6
So, after 10 years, Sam will have in her account around $12,505 even though she contributed only for 2 years.
This is assuming the market didn’t have a major crash within the 10 years.
401K Retirement Account Benefits
Besides its amazing benefits of growing the money, the 401K retirement account is tax-deferred. This means the contributed money is not taxable (you don’t pay income taxes on it) until you withdraw it after age 59 and ½. This will lower your taxable income; if you are in a high-income tax bracket, you can lower your taxable income by maxing out your 401K. For 2022, the max is $20,500
What is Roth 401K?
Roth 401K is also an employer-sponsored retirement account. However, the contribution will be taxed. That means the money will be contributed to your account after your income is taxed. The money will be invested as well and grow but you will not be taxed on the earnings when you withdraw the money after age 59 and ½. Roth 401K can help reduce your post-retirement tax. It is good for those who think their income during retirement will be high and may put them in the high tax brackets
Are the 401K Retirement Account and The Compound Interest Halal?
This section is for my fellow Muslims. The halal literal meaning is permitted. The opposite of Halal is Haram. Muslims pay attention to the money source, and it should not violate the core tenets of Islam. The money is considered haram if the source is haram, such as gambling, alcohol sales, conventional interest-based financial services (interest (Riba) and debts), pork products, and pornography.
The same rule is to investment, Muslims need to make sure that the company they are investing in it and the gain it gives is halal.
Unfortunately, most funds in the employer 401K do gain their earnings from interest. Luckily, there is a way to manage your own investment and pick your own funds through a Brokeragelink account but not all companies offer that option.
Compound interest is basically again, if the company you are investing in is considered halal, then the gain is halal.
Key Takeaways
It is very important to invest in your future self and make sure you have enough money to fund your retirement.
If your employer offers matches, make sure to contribute at least up to the match, otherwise, you will be leaving free money.
Starts as early as you can, the longer you are investing, the more you will benefit from compound interest.
Contributing to a 401K account can save you some money on taxes
401K as a principle is Halal, but the offered funds may not be.
