If you work and are already saving for retirement or expect to start soon, investing in a 401(k) plan can help you develop a substantial nest egg. If you are considering opening a 401(k) or want to learn more about maximizing the benefits of this kind of retirement savings tool, here’s all you need to know.
List of Contents
- What Exactly Is a 401(k)?
- Types of Employer-Sponsored Retirement Plans
- The Differences between a 401(k) and an IRA
- An Employer Matching
- The Limits of a 401(k)
- The Withdrawal Rules of a 401(k)
- What Occurs to Your 401(k) If You Find a New Job?
- Is It Worth Having a 401(k)?
What Exactly Is a 401(k)?
A 401(k) is a retirement savings plan. Significantly, it is offered by an employer to help you plan for the future. Moreover, it also provides you with significant tax benefits. Employees who participate in a 401(k) plan can direct a certain portion of their income to be automatically deducted from each paycheck and placed in their retirement savings account. The participants can select how they would like their money to be invested, which typically consists of several mutual funds.
Types of Employer-Sponsored Retirement Plans
There are wide varieties of retirement plans employers offer, including the following offer.
1. Traditional 401(k)
Typically, you pay contributions into your traditional 401(k) account using money that has not yet been taxed. Since your contributions are deducted from your paycheck before you pay any taxes, the amount of your income subject to taxation will be reduced. If you made $80,000 in 2021 and contributed $5,000 to your 401(k), the amount of your income subject to taxation will be lowered to $75,000 that year.
On the other hand, when you start taking money out of your account in retirement, the taxes that apply to your contributions and investment returns will typically be paid in full. The tax rate that was in effect when you made the withdrawal will be used to calculate the amount of tax owed.
2. Roth 401(k)
When you contribute to a Roth 401(k), you do it with taxed money. This indicates that you won’t be required to pay taxes on any of your contributions or earnings after you reach the age of 59 and a half or later. At this point, you can begin collecting distributions from your account, which will get taxed when you collect any of them.
Nonetheless, your preferences and the options provided by your employer should be both factors in your decision on whether to invest in a traditional or Roth 401(k) plan. It depends on whether or not your employer provides 401(k) plans for its workers. If they do, you may have the option of investing in either or both of them.
3. 403(b) & 457(b)
You may be permitted to enroll in a 403(b) plan if you are an employee of a public school, state institution, religious organization, non-profit organization, or any entity that is exempt from paying taxes. Moreover, it is possible that you could be eligible to join a 457(b) plan if you are an employee of a state or local government, such as a teacher or a police officer. The contribution limits and investment choices available through these programs are often comparable to those provided by 401(k).
The Differences between a 401(k) and an IRA
The main difference between a 401(k) and an Individual Retirement Account (IRA) is that the former is made available to participants by their employers. However, the latter must initiate the creation of the account for themselves. However, Individual Retirement Accounts (IRAs) may not provide participants benefits such as employer matches or a larger contribution limit. Moreover, they may give participants more freedom, and investment choices than 401(k) plans can offer. Depending on how much money you make, you might be able to put money into the retirement plan your company offers and a traditional or Roth IRA.
An Employer Matching
An employer match occurs when a company matches an individual employee’s 401(k) contribution up to a particular amount. Most organizations that provide an employer match base their contribution on a proportion of what an employee contributes.
For example, an employer may match 50% of the first 6% of an employee’s contribution. Therefore, if your yearly salary is $60,000, and you choose to contribute 6% to your 401(k) each year, you will contribute $3,600. As a result, your employer will match 50% of that, or $1,800. You can contribute more of your salary, but your company’s match is limited to $1,800.
The Limits of a 401(k)
The maximum amount that an employee can contribute pre-tax or make Roth deferrals to their 401(k) account individually in 2022 is $20,500. This restriction will remain in effect. If you are over 50, you are eligible for a “catch-up” limit that allows you to contribute an additional $6,500. This brings the total amount that you are able to contribute to $27,000 if you are over the age of 50. In comparison, the maximum contribution you may make to an IRA or Roth IRA each year is $6,000 ($7,000 if you are over 50).
The Withdrawal Rules of a 401(k)
1. Early withdrawals
Genuinely, it is not permitted to withdraw money from your 401(k) if you are still working and are under the age of 59. However, there are some circumstances in which you may be eligible to request a hardship withdrawal. These circumstances include the following.
- Education costs for you or your family
- Medical or funeral expenses for you or your family
- The costs involved in the purchase or repair of your house
- Preventing your quick eviction from your primary residence or its foreclosure
In general, hardship distributions of pre-tax contributions and earnings are subject to tax, and a 10% early withdrawal penalty may also apply. Hardship distributions cannot be rolled over into an IRA.
You may be able to borrow up to fifty percent of your savings or fifty thousand dollars from several programs. However, you will be required to repay the loan and interest, often within five years. You are able to deduct from paying any taxes or penalties. Moreover, any interest that you pay will be deposited back into your account rather than going to the government.
On the other hand, if you quit your work at the moment, you can be expected to repay the entirety of your loan within a relatively short period. If you have not been keeping up with the payments on your loan, you will be responsible for paying taxes as well as a 10% penalty cost.
3. Withdrawals in retirement
In this case, the age at which you can withdraw money from your 401(k) account without incurring any penalties is 55. If you quit your job before the age of 55, you are subject to a 10% early distribution penalty up until the age of 59, regardless of when you started receiving benefits. However, you should be aware that the Internal Revenue Service (IRS) will not allow you to indefinitely retain your money in your 401(k) account. When you reach the age of 72, you are required to start withdrawing money from any retirement accounts you own and have a balance.
What Occurs to Your 401(k) If You Find a New Job?
You can no longer contribute to your old employer’s retirement plan when you change jobs. If you are not yet ready to retire, you have several options to do with the remaining funds in your 401(k) as follows.
- Keep the money in the plan of your old company
You will no longer contribute earnings to it. However, some employers may let you keep your 401(k) active provided you have reached a particular vested balance, typically more than $5,000. In this case, you will not be able to contribute earnings to it, but you will be able to keep it active.
- Transfer your balance to the plan of your current employer
It is expected that doing this would not result in any tax penalties. Moreover, it will enable you to invest in a new plan.
- Move or roll over into an IRA
With a rollover IRA, there are no tax penalties. Thus, you may be able to invest in alternatives that were not available to you through your original 401(k). While automatic payments will no longer be made, this might be a great moment to consolidate your funds, especially if you have had various jobs with multiple 401(k) programs over time. Before making a choice, weighing the advantages and downsides of rolling over to an IRA is essential.
Suppose you left your employer before age 55 and are under 59. You would still be required to pay income tax and a 10% penalty if you withdraw your vested amount from your 401(k). This can end up costing you a significant amount of money for your working life.
Is It Worth Having a 401(k)?
If it is used properly, a 401(k) plan is one of the most appealing methods to save for retirement. You will benefit from tax-deferred or tax-free growth on your investment, as well as additional tax benefits on contributions if you use a regular 401(k) or tax-free withdrawals if you use a Roth 401(k). That means you can invest in some of the best-performing assets, such as stock funds, and enjoy strong long-term returns while paying the least taxes.
Furthermore, you may be eligible for free match money from your employer simply by contributing to your retirement. That is easy money you cannot afford to pass up. Unsurprisingly, millions of Americans have saved trillions of dollars in 401(k) plans.
In short, a 401(k) plan allows you to save for retirement while reducing your tax burden. Not only are the gains tax-free, but contributions are also automatic and deducted from your salary. Furthermore, many companies will match a portion of their employees’ 401(k) contributions, giving them a free boost to their retirement savings.
Read more: Retirement Planning