A 401(k) is an employer-sponsored retirement plan that allows you to gain tax advantages while placing money in long-term investments for your retirement. You’ll sign up for a plan and set an amount to be deducted from each paycheck and deposited in your 401(k) plan. Some employers may match a portion of your contribution. The money in your 401(k) may be placed in selected investment vehicles, often mutual funds.
There are several types of 401(k) plans. The difference is mainly in the type and timing of their tax advantages. You’ll have to ask your employer what types of 401(k) are available.
How a 401(k) Works
Employers decide whether to offer their employees a 401(k) plan. They are not required to offer a plan. Different employers may offer plans with very different terms.
Employers that choose to offer a 401(k) retain a 401(k) Administrator, often a specialist financial management company, to manage the 401(k). You can usually manage your account through a website run by the administrator.
You will decide what percentage of your paycheck you will contribute to your 401(k). Your employer will then deduct that sum from your paycheck and remit it to the plan administrator to be placed in your account.
There is a limit to the amount you can contribute each year and retain the tax benefits of the 401(k). That limit may change from year to year. For 2020 the limit is $19,500 for workers under age 50 and $26,000 for workers over age 50.
Many employers will also contribute to their employees’ 401(k) plans. Those contributions may follow a number of different formulas:
- Matching. Your employer will match a portion of your contribution, according to a fixed formula. For example, they may choose to match every dollar up to 2% of your pay, then 50 cents for every dollar for the next 2%.
- Non-elective sharing. In a non-elective system, the employer puts a fixed percentage of every employee’s pay into a 401(k) plan regardless if that employee contributes.
- Profit-Sharing. Some employers may choose to make annual or quarterly contributions to employee 401(k) plans based on the company’s profit for that period.
Employers are not required to contribute to a 401(k) plan. Ask your employer about their policy.
The plan administrator will offer a range of investments. This will usually be a selection of mutual funds. You can select the funds that you prefer, according to your risk tolerance and preferences.
If you change jobs, you may be able to hold your 401(k) without making further contributions, roll over your holdings to a new retirement account, or withdraw your holdings, depending on the amount you have in your account.
After you retire, you can withdraw the funds in your 401(k). When you reach a certain age you may be required to meet a mandatory disbursement level. You may be able to access 401(k) funds before retirement, but you may have to meet certain conditions, forfeit tax benefits, or pay a penalty.
Types of 401(k) Plans
There are several types of 401(k) plans. The most popular are the Roth and Traditional plans. The differences lie mainly in the tax benefits.
- If you have a traditional 401(k) plan, the money you contribute to your plan will be deducted from your salary before your taxes are withheld from your paycheck. This lowers your taxable income and reduces your tax payments. You will pay income tax on this money when it is disbursed after your retirement.
- If you have a Roth 401(k) the money you contribute to your 401(k) is taxed when you contribute it. The deduction is made after your income tax is withheld. You will not pay any tax on the money or any investment earnings when the money is disbursed after retirement, as long as you are over age 59 ½ and you have had the account for at least 5 years. You will still pay taxes when withdrawing money contributed to your plan by your employer.
If you are in a relatively low tax bracket now but expect to be in a higher tax bracket eventually, consider a Roth 401(k), if your employer offers both. Since you’re in a low tax bracket, your contributions will be taxed at a relatively low rate. Your investment earnings will also have more time to accumulate.
If you are near retirement and expecting your income to drop after retirement, a traditional 401(k) may serve you better. You will defer your tax payment until you are retired and earning less, so it will be taxed at a lower rate.
If your employer offers both traditional and Roth 401(k), consider investing in both, which will spread out your tax liabilities.
How Much Should You Contribute?
Many financial experts advise saving 10% of your pre-tax salary for retirement. That goal may not be practical for everyone. Contribute as much as you can without placing stress on your finances.
If your company offers a matching contribution, make sure you contribute enough to get as much as the company is willing to contribute. If you don’t meet the maximum matching level you are turning down free money.
You will have to keep your annual contribution below the maximum annual limit. If you wish to contribute more, you might want to consider other saving and investment options:
- Open an IRA in addition to your 401(K).
- Consider setting up your own investment account with a broker.
Base your retirement savings strategies on your current income and expenses, your expected income and expenses later in your career, and your own personal goals. If you need to clarify your goals and the ways you can meet them, consider consulting a professional financial adviser.
Using Your 401(k)
If you use money from your 401(k) before age 59 ½ you will pay a 10% early withdrawal penalty, with some exceptions. Once you reach age 59 ½ you have several options:
- Regular distributions pay the funds in your 401(k) at regular intervals, like a salary.
- Non-periodic distributions release funds as you need them.
- Lump-sum payments release the entire sum at once.
If you have a traditional 401(k) these distributions will be subject to income tax. If you have a Roth IRA only your employer’s contributions will be taxed on disbursement.
You are not required to take distributions from your 401(k) at age 59 ½. If you continue working you can keep contributing to your 401(k). If you retire you can let your 401(k) continue to earn investment income without taking distributions. Your plan administrator must maintain your plan if you have more than $5000 invested.
When you reach age 72 you may have to take required minimum distributions from your 401(k).
There are ways to use money from your 401(k) before retirement:
- A 401(k) loan allows you to borrow from your 401(k). You will not earn investment income on the funds you borrow, and if you fail to pay them back they will be taxed as income unless you have a Roth 401(k).
- A hardship withdrawal allows you to get money from your 401(k) without penalty under certain specific conditions. Not all 401(k) plans offer hardship withdrawals. Check with your employer or plan administrator.
Any other withdrawal will be subject to both taxes and a 10% penalty.
A 401(k) is a popular and effective way to save for retirement. If your employer offers one, and especially if your employer is willing to match a portion of your contribution, participating in the plan is an option worth considering. Understanding how a 401(k) works will help you maximize the value of your plan.
If you hope to start investing directly someday, starting a 401(k), managing it actively, and tracking the performance of your portfolio is a great way to get familiar with investment markets and investment options.