Everyone knows it's important to save for retirement. According to a 2020 study by TD Ameritrade, most Americans hope to retire by 67 and more than half have a plan in place to do so. If you're among those who are wondering where to start, you may have considered a 401(k) as an option.
A 401(k) is one of several retirement vehicles that can help you plan for the future. Here's what to know.
A 401(k) plan is a tax-advantaged retirement account offered by employers in the US. This retirement vehicle is named after Section § 401, subsection k, of the US Internal Revenue Code.
This type of account allows employees to save for retirement by contributing a portion of their income to the account over time. Contributions are made through payroll every pay period. Employees can choose to contribute a percentage of their salary or a fixed amount up to a certain limit. These investment vehicles are tax-advantaged, meaning they lower your taxable income since they're funded with pre-tax money — and the funds in the account grow tax-free.
Some employers contribute to employees' 401(k) plans by offering an employer match. For example, an employer may offer to match an employee's contributions dollar-for-dollar up to the first 5% of the employee's salary.
Employer contributions often come with strings attached, such as a vesting schedule. Vesting means employer contributions and earnings on them are not property of the employee until certain conditions are met. Most times, employers require employees to be employed for a defined period before all employer contributions and earnings become the employee's property.
There are two types of 401(k) plans: traditional 401(k)s and Roth 401(k)s. Not all employers offer both types of 401(k) plans.
Here's how they work:
For 2021, the maximum amount an employee can contribute to a 401(k) is $19,500. Employees age 50 or older can make a catch-up contribution of $6,500 for a combined total limit of $26,000.
These limits apply to both traditional 401(k) plans and Roth 401(k) plans, even if you split your contributions between the two. If you change employers part way through the year, your total 401(k) contributions cannot exceed this limit.
Another important thing to keep in mind: 401(k) contributions cannot exceed an employee's income. For example, If you make $15,000, you can't contribute $19,500 to your 401(k) plan.
However, employer contributions are not subject to this limit. Overall, employee and employer matching contributions cannot exceed $58,000 (or $64,500 for employees age 50 or older). Some employers allow employees to make after-tax non-Roth contributions, which are subject to this limit.
Here's a quick overview:
If you're looking to withdraw money from a 401(k), keep in mind that there will be taxes — and even fees — to pay, depending on the type of 401(k) you have, your age, and other factors.
Let's look at each scenario where you can withdraw funds before retirement:
While 401(k) plans allow your savings to grow until retirement, there are ways to access the money early. Just keep in mind that it will cost you — both in penalties right now and in lost earnings down the road.
Money withdrawn from a 401(k) plan before age 59.5 will be subject to a 20% federal income tax and an additional 10% penalty from the Internal Revenue Service (IRS). This means if you withdraw $5,000, your plan administrator will withhold $1,000 (20%) and you will owe the IRS $500 when you file your taxes, leaving you with $3,500.
While you can't avoid the federal income tax in most cases, there are ways to avoid the 10% penalty in certain situations:
Once you reach 59.5 years of age, you can access the money inside your 401(k) account without paying a penalty. Depending on the type of plan you have, you may be on the hook for income taxes on any distributions.
"As a practical matter, most people transfer their 401(k) to an IRA before or during retirement," says Sean Mullaney, CPA and financial planner with Mullaney Financial & Tax. They can choose the financial institution where they roll over the money and will have access to a wider variety of investment options than offered by most 401(k) plans.
Starting at age 72, individuals must start withdrawing required minimum distributions, called RMDs for short, from their 401(k) account. If they still work for an employer at age 72 or older, they will not need to take RMDs. Mullaney says this exception generally does not apply if the employee has a substantial ownership interest in the employer.
Getting started investing in a 401(k) is fairly simple. You'll need to set up your account with your employer and decide how much of your paycheck you want to contribute each month.
The 401(k) plan administrator offers employees investment options such as mutual funds, index funds, and exchange-traded funds. You can decide which funds to invest in and how much of your contributions to invest in each fund. For example, you can decide to divide your monthly contributions between a total market
index fund
and a bond index fund.
Investing options vary from plan to plan. It's important to review fund performance and choose funds that align with your risk tolerance and long-term goals.
Sometimes you may need early access to the funds in your 401(k) if something comes up. In this case, you can take out a loan against your balance, which is known as a 401(k) loan. You can borrow up to 50% of your vested balance or $50,000, whichever is less, while avoiding penalties. You'll have five years to repay the loan, but this may be different depending on your plan rules.
The good news is that you won't be depleting your retirement savings permanently and any interest you pay will go back into your 401(k). However, you will be on the hook for origination fees. And if you cannot pay back the loan within the specified time frame, the IRS considers it a distribution, so you will have to pay income tax and the 10% penalty.
If you leave your job, get laid off, or are fired before you repay the loan, the plan sponsor may require that you repay the outstanding balance immediately. If you don't, it may be reported to the IRS as a distribution and subject to federal tax and an early withdrawal penalty.
A 401(k) account can be a great way to save for retirement and minimize your tax burden. It allows you to save for retirement in a tax-advantaged way. Since the money is automatically deducted from your paycheck, it makes it easy to save. Many employers also offer a match, helping your retirement savings grow faster. You should always contribute enough to your 401(k) to capture the full employer match every year if you can. This is free money, should you meet the vesting schedule, and is part of your total compensation package.