What is a 401(k) plan? Learn the basics.
Are you worried about saving enough money for retirement? Do you want to invest in your future but aren't sure where to start? Saving for retirement is a critical financial goal that everyone should prioritize. One of the most popular retirement savings vehicles is the 401(k) plan, which is offered by many employers as a benefit to their employees.
A 401(k) plan allows individuals to contribute a portion of their pre-tax income into an investment account, where it can grow tax-free until retirement. However, despite its popularity, many people are still confused about how 401(k) plans work, how to maximize their benefits, and what potential pitfalls to avoid.
What is a 401(k) plan?
Although it may look more complicated than it really is, a 401(k) plan is a retirement savings plan offered by many American employers. This type of retirement account is named after section 401(k) in the Internal Revenue Code (IRC). When you sign up for a 401(k) plan through your employer, you agree to direct deposit a percentage of each paycheck to an investment account. In some cases, your employer may match a portion or all of your contribution. The 401(k) plan was designed by Congress to persuade Americans to save for retirement. Not all employers offer a 401(k) plan, so you may consider checking on that before accepting a job offer.
Types of 401(k) Plans
There are two main types of 401(k) plans; they differ in the types of tax advantages they offer:
With a traditional 401(k) plan, your contributions are made with pre-tax dollars, so you get a tax break upfront. In turn, this tax break helps to lower your current income taxes. Your money in a traditional 401(k) account grows tax-deferred until you withdraw it. At the time of withdrawal, typically at retirement, your money is considered ordinary income and you will be required to pay the current tax rate. You may also have to pay state taxes as well.
With a Roth 401(k) plan, your contributions are made with your after-tax income, meaning that contributions come from your paycheck after all income taxes have been deducted. As a result, there is no tax deduction when you withdraw your investment.
Contributing to a 401(k) Plan
A 401(k) plan is one of the most common and easiest ways to start saving for retirement. 401(k)s are known as defined contribution plans, meaning that employees and employers can both make contributions to the accounts up to certain dollar limits that are set by the Internal Revenue Service (IRS). Contribution limits are adjusted regularly to account for inflation.
You must be eligible to participate before you can enroll in a 401(k) plan through your employer. This should not be an issue because federal law requires that when an employer sponsors a plan, all employees must have an equal opportunity to save. There are two restrictions your employer can impose:
- You must work for a full year (typically 1,000 hours over 12 months)
- You must be 21 years old before you enroll
However, not all employers make you wait! When starting a new job, you will want to ask when you’ll be eligible to contribute to a 401(k) plan.
If your company offers any type of employer match, take advantage of it! According to the IRS, matching contributions:
- Are contributions your employer makes to your retirement plan account if you contribute to the plan from your salary
- Don’t reduce the amount you can contribute to the plan from your salary
- Grow tax-free while in the plan, and
- Are taxable only when withdrawn from the plan
The retirement plan information your employer gives you will tell you all the details about the matching contribution (if offered) including how long you must work before receiving the contributions, the matching formula, and how much you must contribute to fully benefit from the match.
Review all your investment options, including possible fees.
Think about your 401(k) as a bowl to hold your retirement savings. What you put into the bowl (the particular investments) is up to you – within the limits of your specific plan. In addition to the specific investment options, make sure you review all fees for your investments (fees can also be referred to as management fees or expense ratios). As a rule of thumb, avoid any mutual fund that charges more than 1%.
Consider diversifying your savings.
A good way to do this is by contributing money to other accounts outside of your 401(k). Learn more about IRAs and other types of investments.
How does my 401(k) account earn money?
The contributions you make (and your employer’s matched contributions, when applicable) to your 401(k) are invested according to the investment choices you select from the options your employer provides. These investments typically include a variety of stock and bond mutual funds and target-date funds.
A variety of factors determine how quickly and how much your money will grow in your 401(k) account:
- The amount of money you contribute
- Employer matches
- The investment accounts you select from your employer's plan
- The annual rate of return on those investments
- The number of years you have until retirement
- As a rule of thumb, the younger you are when you start contributing to a 401(k) or other retirement accounts, the more money you have the potential to earn. So, if you’re not saving for retirement yet, start today!
Withdrawing From Your 401(k) Account
Until you’ve reached retirement age, withdrawing money from your 401(k) account is difficult to do. Because this account is set up as a retirement fund, the U.S. Government imposes a 10% penalty tax on any withdrawals before the age of 59 ½. In addition to the 10% penalty tax, if you’re withdrawing from a traditional 401(k) early, you will also be required to pay any taxes you owe.
However, in certain hardship situations, you may be eligible to withdraw money from a 401(k) before the plan’s normal retirement age without the 10% penalty tax. (Note: penalty-free does not mean tax-free – if you’re withdrawing from a traditional 401(k), your pre-tax contributions will be taxed at the current income tax rates.)
Should I have a Traditional 401(k) or a Roth 401(k)?
Today, many employers offer both Traditional and Roth 401(k)s. So, where should you invest your money? As a rule of thumb, if you expect to be in a lower tax bracket after you retire you may consider a traditional 401(k) for the immediate tax break. However, if you expect to be in a higher tax bracket after retiring you may opt for a Roth 401(k) so you can avoid paying taxes on your savings later.
Another consideration if you are many years away from retirement – there is no tax on withdrawals from a Roth 401(k), so your money can grow tax-free for decades.
While these are general rules of thumb, it is impossible to predict exactly what tax rates will be when you retire. Because of that, you may consider diversifying by putting money into both a Traditional 401(k) and a Roth 401(k).
Further Resources on 401(k) plans
Ensure you choose the right type of 401(k) plan with these helpful resources.
- The Internal Revenue Service (IRS) has detailed information on 401(k) plans, including contribution limits, distribution rules, and tax implications.
- The U.S. Department of Labor provides guidance on the Employee Retirement Income Security Act (ERISA), which governs 401(k) plans, as well as resources on plan administration and compliance.
- The Financial Industry Regulatory Authority (FINRA) offers tips and tools for investing in 401(k) plans, including information on fees, investment options, and risk management.
The Bottom Line
No matter what age you are, it is vital that you save for retirement. A 401(k) is a great employer-sponsored option for you to do just that! With so many options and possibilities out there, planning your financial future can be a confusing journey. That's why the professionals at U1 Financial Advisors are here. Set up an appointment with a U1 free Financial Advisor to learn more about 401(k)s.
Source: Your Money Further™ Personal Money Solutions: https://www.yourmoneyfurther.com/personal-money-solutions/investing/what-is-a-401k-plan-learn-the-basics
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