In this beginner’s guide, you’ll learn the 401(k) basics to help you take advantage of your employer-sponsored retirement plan.
401(k) plans are often discussed when the topic of retirement comes up. It’s commonly used but many don’t know what the actual rules that govern 401(k)s.
What is a 401(k)?
A 401(k) is a retirement savings plan sponsored by an employer. 401k of the Internal Revenue Code authorized the use of a defined contribution plan that allows the employee to make pre-tax contributions to a retirement savings plan. It lets workers save and invest a piece of their paycheck before taxes are taken out. These contributions and any earnings from the 401(k) investments are not taxed until they are withdrawn.
How does a 401(k) plan work?
Under these plans, also commonly known as defined contribution plans, you can save money toward your retirement on a tax-deferred basis. This means you don’t pay federal or state income taxes on your savings or their investment earnings until the money is withdrawn at retirement. A defined contribution plan is a type of retirement plan in which the employer, employee, or both make contributions on a regular basis.
With 401(k) plans, you decide how much to contribute up to a limit set by the IRS and what you want the money in your plan to be invested in. Your employer’s plan will have a limited selection of investments for you to choose from. These plans are administered by a retirement plan administrator contracted by your employer.
When you leave your job, you still maintain ownership over your account.
What are the benefits of 401(k)s?
These plans have tax-advantaged benefits and can support your goal of achieving financial independence. Most 401(k)s are pre-tax contributions. You don’t pay taxes until you withdraw the money at retirement with the earliest at 59.5 years old. Since you contribute pre-tax dollars, your gross income is lowered by your contribution amount and can reduce your current year’s tax obligation.
Many employers also agree to match your 401(k) contributions. Depending on your employer, they may match dollar-for-dollar or a percentage of your contributions. For example, an employer may offer 50 cents for every dollar you contribute, up to a certain percentage of your salary (perhaps 3% to 6%). So, if over the course of the year you contribute $5,000, your company would put in $2,500. Think of this matching contribution as free money. You want to contribute at least the match so you don’t leave money on the table.
In the event your finances sour, your retirement plan is protected from creditors or judgments. Your qualified retirement plan is protected by the Employee Retirement Income Security Act of 1974 (ERISA) from claims by judgment creditors.
How to contribute to a 401(k) Plan
You must be employed by a company that offers a Defined Contribution Plan such as a 401(k). A Defined Contribution Plan is a retirement plan where an employer and/or an employee contributes money with each paycheck that is invested.
Many employers offer a 401(k) Plan as part of their employee benefits package. When you start a new job you can enroll with your company’s 401(k) Plan. Learn more about enrolling in a 401(k).
What are the Maximum 401(k) Contribution Limits
The maximum pre-tax contribution dollar amount is set by law and adjusted for inflation annually. Try to contribute at least enough to qualify for your company’s maximum matching contribution. By not contributing the company’s maximum matching contribution you are leaving money on the table. Ask your Human Resources department how much you need to contribute in order to get the best match.
However, given the plans’ valuable tax breaks, it makes sense to invest the maximum if you can. There are annual limits. Check IRS.gov for changes to the annual limits.
Calculating how much to contribute to a 401(k)
Start by making sure you are contributing at least the percentage amount that your company is matching. If they match 5%, make sure you contribute at least 5%.
Most 401K plans have retirement goals based on the number of years before retirement using target-date funds. It’s an easy way of gauging how much you need to invest, at what risk level, and the years in order to live the lifestyle you envision living when you retire.
Some financial experts recommend 20% of your income should go into long term retirement savings. This could be a combination of 401k, IRA, or other investments that are specifically set aside for retirement.
You could start at 10% and increase the contribution by one percent each year. If you are wondering what the impact on your take-home pay after a percentage increase, check out Fidelity’s Take Home Pay Calculator. A percent increase in contribution may only mean a few dollars less on take home.
Vesting of Matching Contributions
Any money you contribute from your paycheck is always 100% yours. But company matching funds usually vest over time – typically either 25% or 33% a year, or all at once after three or four years. Once you’re fully vested, you can take the entire company match with you when you part ways with your job.
Transferring your 401(k) plan after changing jobs
You can transfer your 401(k) account from your former employer to an Individual Retirement Account (IRA). This is considered a 401(k) rollover and offered by many online brokerages. The simplest way to transfer is through a trustee-to-trustee to eliminate any potential tax consequences for early withdrawal.
- Request the distribution forms from your former employer.
- Make sure you open your new IRA before the transfer so that you can provide the account information on the required forms. There are no penalties with a trustee to trustee transfer, but if you allow your former employer to send the funds directly to you and not to your new IRA, they will be required to deduct and remit 20% of the total to the IRS.
Find a retirement account to rollover your 401(k) in the financial marketplace.
Difference Between 401(k), a 403(b), and a 457(b)
The 403(b) and the 457(b) are plans that are both tax-deferred. Generally, a 403(b) plan is available to employees of educational institutions and a 457(b) is available to governmental employees. The IRS Internal Revenue Code allows educators to use both the 403(b) and 457(b) plans to prepare for retirement.
Generally speaking, 457(b) plans are easier to take money out once you’ve retired. It’s important, however, to compare your 403(b) and 457(b) plan options as some school districts have better investment options through the 457(b) plan or through the 403(b). Consider the fees and other options when deciding.
Additionally, the 457(b) plan is tax-deferred while employed by the governmental institution but when you leave you cannot roll the plan into an Individual Retirement Account (IRA). If you take the funds out, you’ll pay taxes but with no penalties. In contrast, the 403(b) is a qualified plan that reduces your income and is transferable to an IRA if and when you leave the educational institution.