What is a 401(k) Plan?

A 401k retirement plan is one of the best ways to invest for your retirement. Here’s a look at what is a 401k plan.

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You’ve probably heard of a 401(k) plan and know that it’s a way to save up for retirement, but these employer-sponsored plans have many benefits you may not realize. Perhaps the biggest benefit of a 401k plan is that you can contribute part of your earnings and pay no taxes on your contributions or the interest earned on your account until you withdraw the money at retirement. Since your employer withholds your 401(k) contributions from your paycheck, you don’t have to itemize the contributions on your tax return to get the tax benefit.

Employer 401(k) Match Programs

Some employers match your 401(k) contributions up to a certain percentage. For example, if your employer does a 50% match, they’ll contribute $500 for every $1,000 you contribute. Employers have matching programs not only to attract talented employees to their companies, but also to get tax breaks since contributions made on your behalf are a tax-deductible business expense.

By law, employer contributions can’t exceed 100% of your compensation. Many employers set a cap on the amount of your salary they’ll match, typically between 3 and 6%.

Some employers require you to stay with the company a certain amount of time before the contributions are actually yours. If you leave the company before you’re vested, you don’t get to take the employer’s 401(k) contributions with you. However, your contributions are yours to keep, withdraw (with a penalty fee), or rollover to a new plan.

401k Contribution Limits

Current 401k contribution limits state that you can contribute a maximum of $16,500 to your 401(k) each year if you’re under age 50. After age 50, you’re allowed an additional catch-up contribution of $5,500. Total contributions to your 401(k), including those you make and those your employer makes on your behalf, cannot exceed $49,000. Employer contributions made on your behalf don’t reduce the amount you’re allowed to
contribute. For example, if your employer contributes $15,000, you can still contribute $16,500.

It’s a good idea to contribute the maximum to your 401(k) plan, especially if your employer has a matching program. Some matching programs don’t kick in until
you contribute a certain amount. But, if you can’t afford to contribute the maximum, contribute as much as you can afford to. While it’s easier to save up for retirement when you’re young (because you have more time to save), it becomes more critical to save as you approach retirement and your savings aren’t where you’d like them to be and harder because you have to save more money to reach your goal.

Roth 401(k) Plan

A Roth 401(k) is similar to a traditional 401k retirement plan in many ways, but opposite in one big way. Contributions to a Roth 401(k) are made post-tax, but when you withdraw the money in retirement, you don’t have to pay taxes on your earnings or contributions as long as you wait until age 59 ½.

Your 401(k) contributions are deposited with a financial institution that administers plans for your employer. Your employer chooses the mutual fund that your 401(k) invests in.

401(k) Withdrawals

You face a 10% tax penalty on most 401(k) withdrawals made before you turn age 59 ½. You’ll also have to pay income taxes on early withdrawals from a traditional 401(k) based on your tax rate at the time of withdrawal. While you do pay the 10% early withdrawal penalty on some Roth 401(k) withdrawals, you don’t have to include the money in your taxable income. There are some exceptions to the 10% penalty:

  • You’re using the money to buy your first home
  • You need to pay expenses associated with a sudden disability
  • To pay for higher education expenses for yourself or your kids
  • You have medical expenses that are more than 7.5% of your gross income
  • The distribution is made to your estate or beneficiary upon your death
  • Financial hardship withdrawal, for example to prevent eviction or foreclosure

It’s a good idea to leave your money in the 401(k) until retirement. After all, you’re putting it away so you don’t have to work when you get older. Your employer may allow you to borrow from your 401(k) as an alternative to withdrawing from it.