What is a 401(k) and how does it work?
What is a 401(k) and how does it work.
A 401(k) is a retirement savings plan offered by some employers. It allows you to make contributions directly from your paycheck. It also gives you advantages that traditional saving or investing accounts can’t provide.
The name 401(k) comes from the subsection 401(k) of the Internal Revenue Code, which establishes this type of plan.
How does a 401(k) work?
401(k)s are defined-contribution retirement plans. That means that a percentage of your salary goes straight to your retirement account. Then, your money is invested in mutual funds, stocks, and bonds that you choose from your employer’s shortlist.
There are two types of 401(k)s: Traditional and Roth. Their main difference is when you have to pay taxes.
In a traditional 401(k), your contributions are pre-tax. Pre-tax contributions give you immediate tax relief because it decreases your taxable income. So, it reduces the amount of tax you pay that year. But, once you retire, you’ll be taxed on your withdrawals (also known as distributions).
On the other hand, your contributions are after-tax in a Roth 401(k). While you won’t get tax relief right away, you won’t have to worry about paying tax during your retirement.
Contribution limits of 401(k)s
Unlike IRAs, 401(k)s don’t have an income limit. It doesn’t matter how much you earn, you can still have one. Yet, there is a limit on how much you can contribute each year.
In 2022, the contribution limit is $20,500. People aged 50 or more can make a “catch up” contribution of $6,500, increasing their limit to $27,000.
For matched contributions, the limit is either 100% of your salary or $61,000 ($67,500 for people aged 50 or older), whichever happens first.
Withdrawing from 401(k)s
401(k)s are designed to encourage people to save for retirement, so they penalize any withdrawals you make before retirement.
The earliest you can withdraw without being penalized is when you are 59 ½.
There are a few exceptions to this rule. You can withdraw the funds early if:
- You die, become disabled, or become unemployed.
- You experience financial hardship.
- The plan terminates, and your employer didn’t establish or maintain a new defined contribution plan.
With the COVID-19 pandemic, the financial hardship rules softened, and it became easier to access 401(k) funds.
What are the benefits of 401(k)s?
When an employer matches your contributions, they give you money for the money that you put into your 401(k) account. Each employer has its matching scheme, but often they match a dollar per dollar or make a partial match–usually 50% or more of your contribution.
In any case, your employer will only match a percentage of your salary. The average match is 4.7% of the employee’s salary, but many companies offer up to 6% of the annual salary.
In both traditional and Roth plans, employer contributions are pre-tax, so you’ll have to pay tax on your withdrawals.
Make sure you don’t leave any free money on the table. If your employer matches your contributions, make sure to save up at least as much as they are willing to match.
With a traditional 401(k), you’ll see an immediate tax relief since you make your contributions from your pre-tax salary.
On top of that, you might even pay a lower tax rate if your taxable income for that year is on a lower tax bracket.
You won’t have immediate tax relief in Roth plans, but you won’t have to pay taxes on your distributions.
In both plans –traditional and Roth– your investments are tax-deferred. You won’t be taxed on interest, net gains, or dividends as long as you hold them in your 401(k) account.
Protected from creditors
Another advantage of 401(k)s is that they are protected from most creditors–unless the creditor is the government. Even if you file for bankruptcy, your creditors can’t claim your retirement savings.
401(k) ‘s FAQs
How much money should I put into my 401(k)?
Financial experts recommend saving up at least 15% of your income towards retirement when you start saving in your 20s.
If your employer matches your contributions, aim to save at least what your employer is willing to match.
How does a 401(k) make me money?
A 401(k) makes money in two ways: one, through investing. The funds you put into your account are invested into bonds, mutual funds, or stocks. It grows as the market grows, and you might earn dividends on top of that, which are reinvested and create compound interest.
The second way is through employer matching. Your employer may decide to match a percentage of your contributions, essentially giving you free money.
Can I lose money with a 401(k)?
Since the 401(k) is in the stock market, its value will follow the market trends. That’s why it’s important to rebalance your 401(k) and manage risk as you get older. In your 20s, you might ride out a crash market better than when you approach retirement.
Consider moving your investment to bonds and more secure investment vehicles as you grow older.
What are the penalties if I cash out my 401(k) early?
If you withdraw before retirement, you’ll face a 10% penalty on your withdrawal and you’ll also be taxed.
If you find yourself in a challenging financial situation, you may be able to take a loan if your employer offers this option. You’ll have five years to repay and will have to pay opening fees and interest — though your interest goes back to your account.
What happens to my 401(k) if I change jobs?
If you change jobs, there are a few options to take your 401(k) with you. If your new employer also offers 401(k), you can roll over your account to the new company.
If not, you may roll it over to a bank within an IRA account.
Your last option is to check with your former employer and see if they allow you to keep your 401(k) with them even if you don’t work there anymore. Make sure you’re comfortable with the company’s management of its 401(k) plan. Remember that you can’t make any more contributions if you don’t work with that company.