Most people have heard about 401(k) plans to save for retirement. What exactly is a 401(k) and how does it work? Let’s look at this effective way to save for retirement and how it can benefit you.
What Is a 401(k)?
Prior to 1978, there were no tax-deferred retirement accounts that a company offered to its employees. The brainchild of consultant Ted Benna, the 401(k) plan allowed employees at his company to avoid paying taxes on parts of their income by not receiving it as wages but placing it in a deferred income account that could make investments that accrued towards retirement.
These 401(k) accounts, named after a section of the Internal Revenue Service (IRS) tax code, quickly became popular and got offered by other companies. It was a way for workers to receive a break on taxes owed that year. The deferred income could make growing investments that kept up with the rate of inflation.
How They Work
401(k) plans have these basic characteristics:
● Eligibility. Your company may allow you to sign up as soon as they employ you, or there may be a waiting period that lasts several months before you have eligibility. Check if your employer automatically enrolls you or if you have to apply for it.
● Participation Level. You choose the amount you want to contribute each month. They usually take it directly from your paycheck as a percentage of what you earn. You may have to contribute a certain amount in order for your employer to offer company matching contributions.
● Company Match. Many employers offer company matching contributions. The company match is usually a match of your contribution as a percentage of your salary. And yes, it’s basically free money!
● Investment Choices. Most plans offer several mutual fund choices from which you can select. They comprise different combinations of stocks, bonds, and other securities that are managed by a fund management team. Watch for investment fees that a fund manager may charge on certain mutual funds, and steer clear of the ones that charge over 1% in fees. Not paying attention to these fees is a common mistake.
● Distribution. You can start making withdrawals from your 401(k) starting at age 59 and a half.
How much money, or the contribution limit, you can put into a 401(k) yearly, is determined by the IRS. They adjust the max amount from year to year to account for inflation.
Currently, the contribution limits are:
● Workers younger than 50 years old can contribute $20,500 annually.
● Workers aged 50 years old and older can contribute $20,500 plus an additional $6,500 as a catch-up contribution. This means if you are over 50, you can contribute up to $27,000 yearly.
Types of 401(k)s
There are two types of 401(k) plans. Your company may offer one or the other, or both. The main difference between the two types is when the taxes get paid.
● Traditional 401(k). The contributions you make are pretax dollars. This means you do not pay taxes now on the money you contribute to the account. As a result, your current annual taxable income is lower. However, you will pay taxes on the money and any investment gains once you withdraw it in retirement. You can start receiving disbursements once you reach 59 ½ years of age, regardless of how long you’ve had the account.
● Roth 401(k). The contributions you make are after-tax dollars. Meaning, you pay taxes on the money prior to adding it to your account. The money and investment gains can grow tax-free. Once you start withdrawals upon retirement, these also are tax-free. Like a traditional 401(k), you can start withdrawals at age 59 ½ but with a Roth 401(k) you need to have had the account for at least five years.
Employer match contributions for both the traditional and Roth plans get taxed upon withdrawal. Both plans also have a 10 percent penalty tax for early withdrawals.
How You Benefit
The 401(k) plans are a no-brainer way to save for retirement. But how many employees actually have one? Less than one-third of the population.
Seventy percent of employers offer some sort of retirement plan like 401(k)s, but so many of those plans are either ignored or passed up. Why is that? Workers may not be interested, aware, or eligible for the retirement account offered.
Don’t miss out on the many benefits! These include:
Tax Advantages. If you have a Traditional 401(k), you will pay taxes on withdrawals once retired, but by that time you may be in a lower income tax bracket, which can save you money. With a Roth 401(k), you pay taxes up front, so your withdrawals upon retirement are tax-free.
High Contribution Limits. These plans have the highest allowable contribution limits of any retirement accounts. Married couples under 50 yrs. old might put $41,000 ($20,500/person) away for retirement. For those 50 and over, $54,000 ($27k/person) annually.
Employer Match. When an employer offers to match your contribution, take it! This is money that you did not have to earn, helping to build your retirement account.
Protection. Federal law protects your employer-sponsored 401(k) from creditors, bankruptcies, and lawsuits. Two entities that have access: ex-spouses during divorce settlements and the IRS if you owe back taxes.
Transferability. Should you leave your job, you can transfer your 401(k) to your new employer’s plan. If your new job doesn’t offer one, you may be able to keep your 401(k) in your former employer’s plan, but you can’t make further contributions to it.
Saving for retirement doesn’t have to be hard. The Traditional and Roth versions of 401(k) plans both offer a no-brainer way to save, hassle-free.