In this simple guide, you’ll learn the 401(k) plan basics to help you take advantage of your employer-sponsored retirement plan. It can be an essential part of your retirement planning.
What is a 401(k)?
Contributing to a 401(k) provides you money in retirement.
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 portion of their paycheck before taxes. These contributions and any earnings from the 401(k) are not taxed until withdrawn.
How does a 401(k) plan work?
You can save money toward your retirement on a tax-deferred basis under 401(k) plans, also commonly known as defined contribution plans. A defined contribution plan is a retirement plan where the employer, employee, or both make contributions regularly. With a 401(k), you don’t pay federal or state income taxes on your savings or investment earnings until you withdraw the money at retirement.
With 401(k) plans, you decide how much to save, up to the IRS’s contribution limit, and choose the investments based on your plan. A retirement plan administrator is contracted by your employer and manages the 401(k) plan participants.
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 affecting your taxable income. 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, you are reducing your gross taxable income.
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 match may offer 50 cents for every dollar you contribute, up to a certain percentage of your salary (perhaps 3% to 6%). So, if in a calendar 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 work for a company that offers an employer-sponsored retirement savings plan such as a 401(k). Many employers offer a 401(k) Plan as part of their employee benefits package. You can enroll with your company’s 401(k) Plan when you start a new job. Learn more about enrolling in a 401(k).
What are the Maximum 401(k) Contribution Limits?
The maximum pre-tax contribution dollar amount is $19,500/year as of 2020, set by law and adjusted for inflation annually.
Try to contribute at least enough to qualify for the maximum matching employer 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 to get the best match.
However, given the plans’ valuable tax benefits, it makes sense to invest the maximum if you can. There are annual contribution limits, so check IRS.gov for changes to these 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 the employer match is 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 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–a combination of 401k, IRA, or other investments that are expressly set aside for retirement.
You could start at 10% and increase the contribution by one percent each year. If you wonder what the impact is 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 vested balance with you when you part ways with your job.
Transferring your 401(k) plan after changing jobs
Through a 401(k) rollover, you can transfer your 401(k) plan from your former employer into an Individual Retirement Account (IRA) offered by brokerage services. The most straightforward 401(k) 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 roll over your 401(k) in the financial marketplace.
401(k) Early Withdrawals
Need to access your money in a 401(k)? If you are younger than 59½ years old, you may face an early withdrawal penalty. There are exceptions to avoid the 10% early withdrawal tax penalty if you aren’t yet age 59 ½. For example, you can request a hardship withdrawal that includes medical or funeral expenses, postsecondary tuition, certain costs related to your primary residences such as buying, damage repair, or eviction prevention. Remember that hardship distributions of pre-tax contributions and earnings are subject to tax and may incur the 10% early withdrawal penalty.
The max employee contribution is $19,500 (in 2020) for those younger than 50 years old. Are you 50 years old or older? Then, you can contribute an additional $6,500 as part of a catch-up contribution. Your total contribution limit is increased from $19,500 to $26,000.
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 essential, 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 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.
Do you need more retirement advice? Seek the help of a financial advisor or tax adviser.