A 401(k) is a retirement savings plan sponsored by an employer. It allows employees to save and invest a portion of their paycheck before taxes are taken out. Taxes aren't paid until the money is withdrawn from the account. This plan is named after a section of the U.S. Internal Revenue Code and is important when it comes to retirement.
How Does a 401(k) Work?
Every time you get paid, you get the opportunity to contribute part of that paycheck toward your 401(k) retirement account (typically through a bank of your choice). You can take part of that paycheck and invest into different assets in that 401(k) account, similar to what we discussed in the IRA article.
The money that you choose to contribute from your paycheck to your 401(k) account is deducted pre-tax, meaning there is more to contribute and that you will not pay taxes until you have to withdraw the money in the late future.
Your employer may also match your contributions up to a certain amount.
To avoid paying a penalty, you must generally wait until you are 59.5 years of age to start taking money out of your 401(k) account.
Advantages of a 401(k)
Tax Benefits: The immediate tax reduction on contributions to a traditional 401(k) and the tax-free withdrawals from a Roth 401(k) can be significant advantages.
Employer Matching: This is essentially free money that can accelerate your retirement savings.
High Contribution Limits: The contribution limits for 401(k) plans are higher than those for IRAs, allowing you to save more for retirement. As of 2024, the annual limit is $22,500 for those under 50, and $30,000 for those 50 and older due to catch-up contributions.
What is a Roth 401(k)?
A Roth 401(k) is a type of retirement savings plan where contributions are made with after-tax dollars, meaning you pay taxes on the money before it goes into the account. Unlike a traditional 401(k), withdrawals from a Roth 401(k) during retirement are tax-free, provided certain conditions are met. This allows for potentially significant tax savings in retirement, especially if you expect to be in a higher tax bracket.
Withdrawals and Loans
Early Withdrawals: Withdrawing money from your 401(k) before age 59½ usually results in a 10% penalty on top of the regular income tax. There are exceptions for certain circumstances, such as severe economic hardship or buying a first home, but these come with strict requirements.
Required Minimum Distributions (RMDs): Starting at age 72, you must begin taking required minimum distributions from your 401(k). The amount is based on your account balance and life expectancy. Failing to take RMDs can result in hefty penalties.
Loans: Some 401(k) plans allow you to take out loans against your savings. These loans must be repaid with interest, typically within five years. If you leave your job, you might have to repay the loan in full within a short period or face taxes and penalties.
What happens to a 401(k) when I switch jobs?
When you switch jobs, there are many actions you can take to keep your old savings. First, you can keep your money exactly where it is if your plan allows for it. If you can't do that, then you can move it to a rollover IRA, transfer it to your new 401(k), or take a withdrawal. With a withdrawal, however, you may face a penalty.
Disadvantages of a 401(k)
Limited Investment Choices: Your investment options are limited to the choices offered by your plan. This might not be a concern for everyone, but it can be for those who prefer a broader range of investment options. This is why it is good to have an investment portfolio in an IRA, not just a 401(k).
Fees: Some 401(k) plans come with high administrative or investment fees, which can eat into your returns over time.
Penalties for Early Withdrawal: The penalties and taxes on early withdrawals can significantly reduce the amount of money you save for retirement.
A 401(k) is an essential topic when understanding retirement. To plan for your future retirement, you should plan to have enough saved up in your 401(k) retirement account. This tool is powerful, letting you gain tax benefits and the potential for employer-matching contributions. However, it’s important to understand the rules, benefits, and potential drawbacks of your specific plan. Stay financially literate!
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