What Is a 401k?

What Is a 401k?

Saving is always a mandatory part of a better and more secure future, especially when it comes to your retirement. Luckily, employers offer many plans that make it easier to save for retirement. One such plan is a 401k.

A 401k is an employer-sponsored retirement plan offered under the US Internal Revenue Code section. The employee who chooses this plan agrees to put a portion of their salary into the plan every year, which is automatically taken from your regular paychecks. The deducted amount goes directly into the retirement account, which you can access in retirement.

Read on to learn about 401k plans, how they work, the types, and which plan might be right for you.

What Is a 401k Plan?

As stated above, a 401k is a plan sponsored by your employer that involves deducting a portion of your salary to save for retirement. Furthermore, some employers offer to match a part of or the entire amount you save.

The name was adopted from a sub-section of the tax code permitting employers to offer retirement plans where employees can contribute a portion of their wages.

While there are seven types of 401k plans, with traditional W-2 employment, you’ll typically have the option to choose between two: the traditional 401k and Roth 401k.

In addition to helping you save for retirement, these plans also come with tax benefits. While both traditional and Roth 401ks help you save money, they differ in how taxes are deducted.

Depending on the plan you choose, taxes can be deducted when you make contributions or when you withdraw the funds in retirement. We’ll discuss the differences between traditional and Roth 401ks in more detail later.

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How Does a 401k Work?

While almost all traditional employers offer 401k plans, your eligibility to join the plan will largely depend on how long you’ve worked for the company. Some companies allow you to open a 401k plan within one or two months of getting hired, while most others will require you to work a year.

Once eligible, you’ll need to speak with your HR department to learn the process and options for opening a 401k.

Once you’ve chosen your plan and which financial institution it will be housed with (some employers offer several choices of financial institutions while others may only offer one or two), you’ll need to choose how much you want to save.

The amount deposited into the plan depends upon the contribution rate you select. For example, if you have chosen 10% as your contribution rate, 10% of your salary will go into the 401k plan. Most financial planners suggest saving between 15% and 20% of your gross income for retirement, although you can start with a smaller percentage and increase it yearly as your income grows.

Your contributions will be invested by your chosen financial institution based on your preferences, age, and risk tolerance. Typically, those with more years until retirement will have higher-risk investments since they have more years to recover if the market should take a dip. Conversely, those with fewer years to retirement will typically have less risky investments since they will need the money sooner and can’t risk losing a chunk of it to a market downturn.

Without penalty, you can begin withdrawing from your 401k at age 59.5. While there are exceptions, if you start withdrawing before that age, your withdrawals are subject to a 10% early withdrawal penalty.

While there are no income limits restricting contribution to a 401k plan, there are income limits for accessing all the benefits of these plans.

Below are other essential things to know about 401k plans.

Contributions

There are limits to how much you can contribute to your 401k annually. The maximum amount you can contribute annually depends upon the state of inflation in that particular year.

In 2021, the maximum amount an employee under age 50 can contribute is $19,500. However, the limit for 2022 is $20,500 annually. For employees above 50, an additional contribution of up to $6,500 is allowed in 2021 and 2022.

Moreover, if the employer agrees to make an after-tax, non-deductable contribution to a traditional 401k, the 2021 limit for employees below the age of 50 is either $58,000 or the salary of the employee whichever is less. For employees 50 and above, the contribution limit is $64,500.

For 2022, the annual limit is $61,000 for employees below 50 and $67,500 for employees aged 50 and above.

Another thing you might want to consider is the vesting schedule. This schedule dictates the ownership degree you have over the contributions. It typically takes several years of employment to be fully vested in your plan. Once you’re 100% vested, all the contributions made to the 401k plan can not be forfeited.

You’ll want to know the vesting schedule and your vesting level before you consider leaving your current employer.

Employer Matching

Before we move on to how much the employer can contribute to your plan, let’s understand exactly what employer matching is.

Employer matching is the amount your employer is willing to contribute to your 401k retirement plan. It usually depends upon the percentage selected by you, the employee.

For instance, many employers will agree to contribute a portion of every dollar contributed by the employee. For example, an employer might contribute 50 cents for every dollar you contribute so that if you contribute 3% of your yearly salary, your employer will contribute an additional 1.5%.

Other employers may match dollar for dollar up until a certain percentage, such as 5% or 6%. In this case, your 5% contribution will be matched 100% by your employer so that the actual contribution to your 401k is 10%.

Because employee matching is considered “free money,” it is recommended that you take advantage of whatever contribution terms your employer offers. For example, if they match up to 5%, it is recommended that you contribute at least 5% of your salary to get the full match. If they offer a percentage of your contributions, save as high a percentage as you can afford.

While the terms and conditions for employer matching differ, all contributions are subjected to certain limits. These maximum limits change almost every year depending on market factors like inflation.

Note that all contribution limits are defined by the Internal Revenue Service (IRS). You can also ask your HR department about employee and employer contribution limits.

Pre-Tax Contributions

Pretax contributions are made under a traditional 401k plan. Pretax contributions are made before taxes are deducted from the income, which reduces your taxable income and your tax bill.

However, while pretax contributions lead to an up-front tax deduction, remember that you will have to pay taxes on all the money you withdraw in retirement.

After-Tax Contributions

After-tax contributions are made once income tax has been taken from gross income. Because taxes are paid upfront, the money you withdraw in retirement is not subject to tax.

This type of contribution is relatively new in the market, and not all employers offer this option.

Related:What Is an IRA?

Withdrawals

Retirement plans have many great benefits, but one significant drawback is that once the money is contributed, it’s difficult to access without penalty until you’ve reached 59.5.

While there are situations where you may be able to withdraw early from your 401k without penalty, any withdrawals you make will be counted as income and subject to income tax.

There are also cases where employers might allow you to take a loan against your contributions. However, it is recommended you repay the loan before leaving your job unless you are willing to pay a 10% early distribution penalty.

The bottom line is that money contributed to a 401k should remain in the account until retirement unless there is some sort of emergency. Furthermore, you should only contribute what you can afford so that you don’t end up with the money you need today sitting in an account that’s difficult to access.

Types of 401ks

As stated above, there are two types of 401k plans: traditional 401k and Roth 401k.

Both plans offer tax benefits. Moreover, both plans have no income limits but require minimum distributions/withdrawals after turning 72.

Here’s a description of these two types of 401ks.

Traditional 401k

A Traditional 401k retirement plan allows you to make contributions to the plan from your gross income, meaning all contributions are made before taxes are deducted. This reduces your taxable income and, as a result, reduces your taxes.

However, when you begin withdrawing money from the account after turning 59.5, you will have to pay taxes on all the money you withdraw. This is because you’ve been contributing tax-free money, and your contributions have grown tax-free.

Roth 401k

Money saved in a Roth 401k is part of after-tax contributions. This means that the contributions are made to the plan after taxes were already deducted from the income. Because you’ve paid taxes upfront, withdrawals from a Roth 401k are tax-free, including earnings.

A Roth 401k is a relatively new retirement saving plan offered by some employers. Furthermore, some employers might allow you to make contributions to both plans. However, the limit must be within the contribution limit set for that year.

Also, note that you cannot transfer the amount from a traditional plan to a Roth plan as both differ in terms of tax deduction.

Related Article: How to Invest Your VA Disability Money?

How to Open a 401k

To get started with a 401k retirement plan, you must talk to your employer or the HR department about eligibility. Some companies automatically enroll you under the plan and deduct a certain amount from your paycheck to contribute to your 401k. You can, however, change the contribution amount at any time.

However, you will have to officially enroll in the plan in most cases. The employer will then provide you with the necessary paperwork and ask how much you are willing to contribute. Of course, you can change the amount at any time. In addition, you would also be required to choose a beneficiary who would inherit the earnings in the event you pass away.

In short, to open a 401k, you must carry out the following steps:

  • Talk to your employer to get an idea of the eligibility criteria and enroll yourself in the program.
  • Let the employer know how much you are willing to contribute. You can either choose a specific dollar amount or contribute a percentage of your salary.
  • After selecting the contribution amount, choose how and where the amount will be invested. You can select ETFs and interest funds to enjoy low-fee perks. Advisors from the financial company you’re plan are hosted with can help you choose the best options for you.

When Can You Take Your 401k Distributions?

You can withdraw your 401k contributions once you reach the age of 59.5. Although you can choose to withdraw before you reach 59.5, you would be subjected to a 10% early withdrawal penalty in most cases.

Additionally, you can also choose to withdraw all the earnings at once by getting a lump sum amount. However, know that you would be subjected to a large tax bill and need to monitor your spending carefully.

What Happens to Your 401k When You Quit Your Job?

When you quit a job with a 401k plan, you will generally have the following four options.

Withdraw the Money

You can choose to withdraw the money from the plan. However, this might not be a great idea as you will be subjected to a 10% early withdrawal penalty in addition to the withdrawal taxes.

If you do not want to pay the early withdrawal penalty, you would either need to wait until you turn 59.5 or pass other conditions that make you an exclusion to this clause.

Rollover to an IRA

You can also roll your 401k contributions into an IRA. This will give you new investment options and provide tax defer benefits. However, you must convert the plan into an IRA within 60 days of leaving your job to avoid penalties and taxes.

To get started with it, you can get in touch with a financial institution that will be willing to help you roll over to an IRA.

Leave It With Your Employer

If your account is worth more than $5,000, you can choose to leave it with your previous employer. However, you would not be able to make further contributions in this case. This option makes sense if you are completely satisfied with the investment option offered by the ex-employer.

However, this can impose some difficulties as leaving a 401k plan with different employers can result in forgetting one or more of them. Moreover, if you pass away, your beneficiary might be unaware of the account’s existence.

Move 401k to New Employer

The most common option is to move the plan to your new employer. This will help you avoid immediate taxes, and the account will be able to maintain its tax-deferred status. Plus, you’ll be able to continue making contributions without starting another account.

Who Is a 401k Best For?

401k retirement plans are an excellent option if you are willing to invest and save up for a comfortable retirement. This plan makes saving easy as the contribution amount you choose is automatically deducted from your salary before hitting your checking/savings accounts.

Moreover, the employer might also offer to match a portion of your contribution in some cases, which is generally considered “free money.” This can help you save additional money for retirement.

Picking the Right 401k For You

Picking the right 401k retirement plan depends upon your tax situation and how much you can save. A Roth 401k plan is a better option for people able and willing to save a lot as you would not have to pay taxes when you withdraw the amount. For small savers, on the other hand, choosing a traditional 401k may make more sense.

Consult a financial professional to see which situation makes the most sense for you.

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