401(k)s are employer-sponsored retirement accounts that come with many benefits, such as matching contributions and tax-free savings.
In this guide, I explain the basics of what is a 401(k), how they work, including the types of plans available, annual contribution limit, withdrawal rules, and tax benefits.
- Key Takeaways
- What is a 401(k) plan in simple terms?
- How 401(k) Plans Work?
- Pros and cons of a 401(k) plan
- Rules of a 401(k): Contributions and limits
- Can I contribute 100% of my salary to my 401k?
- Withdrawing money from your 401(k)
- Required minimum distributions (RMDs)
- Rolling over your 401k into an IRA
- How does your 401k grow?
- 401(k) FAQs
My key takeaways from this guide to what is a 401(k) would be:
- Your retirement savings are made up of employee contributions and in most cases an employer match of the contributions made.
- You can pay taxes before you make payments to your retirement account or you can take advantage of making employee contributions before paying income tax. The only downside is you have a tax deduction on the withdrawal.
- Retirement savings can be accessed before the retirement age of 59½ but you will pay an early withdrawal penalty for doing so
- Income taxes are payable whether you pay before you make contributions to your retirement savings plan or when you withdraw the money.
- Investing involves risk so when you are retirement planning is is always worth speaking to a financial advisor or financial institution for advice on the best retirement savings plans available.
What is a 401(k) plan in simple terms?
401(k)s are a retirement savings plan offered by many US employers. They allow you to save for your retirement in a tax-efficient way.
You will generally have two options to choose from for your individual retirement account; a Roth or a traditional 401(k).
- Roth plans allow you to invest with after-tax dollars, so you pay taxes first then invest. When you get to the age of retirement, withdrawals from your Roth will not be subjected to income taxes.
- Traditional plans will see you invest with pre tax dollars, increasing the amount contributed. When you withdraw money, you will pay income taxes as the money is seen as taxable income..
401(k)s come with annual limits, which dictate how much you can contribute. In 2023, you can contribute up to $22,500. If you are over 50, you can make catch-up contributions. This permits an extra $7,500.
You will be given a range of investment options to choose from when setting up a 401(k). This is usually a blend of US, international, real estate, and bond index funds.
When it comes to 401(k) withdrawals, you will need to wait until you are 59 ½ to avoid penalties. Certain exemptions exist, but it’s best to leave your retirement pot untouched until you are eligible for penalty-free withdrawals.
How 401(k) Plans Work?
401(k)s come in two versions, Roth 401(k) and traditional 401(k).
Here’s how each retirement plan works:
Roth 401(k)s allow you to invest with after-tax dollars. In other words, your employer will deduct tax from your income as they normally would.
This means that when you retire, you can make withdrawals from a Roth 401(k) without paying any tax. This option is best suited for investors below the age of 50. This is because your investment gains can grow over many years in a tax-free manner.
Traditional 401(k)s are much the same as Roths. But the key difference is that contributions are made with before-tax dollars.
This means that instead of paying tax on the income contributed, it goes towards your retirement plan. This will increase the amount of each contribution being made.
Conversely, withdrawals made from a traditional plan will be taxed. This will be at the rate of tax you pay when making each withdrawal.
Traditional plans are suited for those over 50, as catch-up contributions can be made.
- In 2023, for example, the over-50s can contribute $30,000 into a traditional 401(k).
- In comparison, this is capped at $22,500 for those aged under 50.
As I will explain in more detail shortly, traditional plans are more restrictive when making withdrawals before the age of 59 ½.
This is because the entire withdrawal will be subject to both tax and a 10% penalty. Roths, on the other hand, are only penalized on the earnings portion of the early withdrawal.
Pros and cons of a 401(k) plan
My guide on what is a 401(k) found the following pros and cons:
- Save for your retirement years in a tax-efficient way
- Some employers will match your contributions up to a certain amount with employer contributions
- You can choose to invest with pre-tax and after-tax dollars
- High contribution limits of $22,500 in 2023
- Those aged over 50 can make catch-up contributions of $7,500
- Withdrawing before the age of 59 ½ will likely result in a 10% penalty
- Limited range of investment options when compared to IRAs
- Your investments can still lose money
Rules of a 401(k): Contributions and limits
The contribution limits of a 401(k) are the same for both traditional and Roth plans. As noted above, basic limits in 2023 for those under 50 are $22,500 – an increase from $20,500 in 2022.
Once again, those aged over 50 can contribute an additional $7,500, up from $6,500 in the previous year.
In addition to the basic limits, your employer might offer a matching contribution program. This will match your contributions by a certain amount, often $0.50 for every $1.
- Let’s say you contribute $5,000 to your 401(k) in 2023
- Your employer adds $0.50 for every $1 contributed
- So on a contribution of $5,000, that’s an extra $2,500
There are a few points to note about matching contributions. First, if your employee offers a 401(k) matching program and you have the financial means, this should be maximized. You are getting free money towards your retirement plan, which will also grow over time.
Second, each employer will have their own terms surrounding matching contributions. In almost all cases, this will be limited each year, based on a percentage of your annual salary.
Third, while employer matching contributions allow you to exceed your annual limit, this isn’t uncapped.
- In 2023, the limit for employee and employer contributions combined is $66,000
- If you are aged over 50, catchup contributions of $7,500 and permitted – so that’s $73,500 in total.
Contributing to both a traditional and a Roth 401(k)
If you find that you exceed the annual limits in any given year, you might consider switching to an IRA. This allows you to continue making tax-efficient contributions toward your retirement plan.
In 2023, you can contribute up to $6,000 to an IRA, or $7,000 if you are over 50. Do note that the contribution limits increase each year, usually in line with inflation.
Can I contribute 100% of my salary to my 401k?
The simple answer is yes – you can contribute 100% of your salary to a 401(k). However, the annual contribution limits that I discussed above still apply.
This means that between you and your employer, you won’t be able to contribute more than $66,000 in 2023 or $73,500 if you are over 50.
Withdrawing money from your 401(k)
It is important to understand the rules surrounding 401(k) withdrawals. This is because certain situations can result in a penalty or tax being owed.
First, if you have a Roth 401(k), then you can make tax-free withdrawals without penalty at the age of 59 ½. However, unlike traditional plans, you will need to have had the Roth for at least five years.
This is another reason why traditional 401(k)s are more suitable for those over the age of 50.
Similarly, traditional plans also permit penalty-free withdrawals from 59 ½, but without a requirement to have had the account for five years.
Unlike Roths, you will pay tax on your traditional 401(k) withdrawals. This is because you did not pay tax at the time of making the contributions.
Is It a good idea to take early withdrawals from your 401(k)?
Ideally, you should wait until you are 59 ½ before you begin withdrawing funds from your retirement plan. But due to the unpredictability of life, there might come a time when you need to access your savings early.
Let’s break down the consequences of making an early 401(k) withdrawal:
On both a traditional and Roth plan, an early withdrawal will result in a 10% penalty and tax being paid. However, Roth plans will only be taxed on the contributions made. Traditional plans are taxed on both contributions and investment gains.
Traditional 401(k) plan:
- Let’s say you have contributed $4,000 into a traditional plan, which is now worth $9,000
- You withdraw the full $9,000
- You pay a 10% penalty, meaning you lose $900
Roth 401(k) plan:
- Similarly, you contributed $4,000 into a Roth, which is now valued at $9,000
- You withdraw the full $9,000
- You only pay a 10% penalty on the contributions ($4,000) and not the investment earnings ($5,000)
- As such, your penalty is $400
There are numerous exceptions to early withdrawal penalties. But do note that tax will always apply.
- Being totally and permanently disabled
- Using the early withdrawal for a down payment on a first-time home purchase. This is capped at $10,000.
- To settle a tax bill with the IRS
- To pay for medical bills that were incurred in the same year as the early withdrawal is made
- If the account owner dies and the spouse makes a withdrawal
There are other exemptions, which can be found on the IRS website.
Borrowing against your 401(k) to avoid penalties
If you have no other option than to make an early withdrawal, you might consider taking out a loan against your 401(k).
You can take a loan of up to 50% of your retirement plan valuation or $50,000, whichever is lower. Most importantly, the 10% penalty and tax can be avoided. You will, however, need to make sure that the loan is paid back on time.
This is usually up to five years, but each circumstance differs. Moreover, the 401(k) loan will be repaid through payroll deduction.
Required minimum distributions (RMDs)
Depending on your age, you might also need to start thinking about the required minimum distribution (RMD) rule.
In a nutshell, this requires you to withdraw a minimum amount from your 401(k) each year if you are over the age of 73. If you don’t withdraw the minimum, serious tax penalties will apply.
In fact, while this was previously 50%, the RMD penalty still stands at 25%. As such, you will lose 25% of anything below your annual RMD.
- Let’s say that your RMD is $30,000 per year
- In 2023, you withdraw $25,000 from your 401(k)
- This means that you are $5,000 short of your RMD of $30,000
- Therefore, you will pay a 25% penalty on $5,000
- You lose $1,250 from your retirement savings
There are some important points to bear in mind about the RMD. First, the RMD amount is determined on an individual-by-individual basis.
This is based on several factors, such as the value of your retirement account and your age. More information about the RMD calculation can be found on the IRS website.
Ultimately, while there are several strategies that you can take to reduce or even avoid the RMD, it’s best to withdraw your full allocation each year.
Rolling over your 401k into an IRA
When you leave your current employer, you will need to make considerations about your 401(k). In an ideal world, your new employer will also support 401(k)s, so it’s just a case of rolling it over.
However, if your new employer doesn’t offer a 401(k), you will need to consider other options.
For instance, you might be able to keep the 401(k) with your old employer. While you won’t be able to make contributions to that specific plan, the investments will still grow in line with the stock markets.
- Perhaps an even better option is to roll over the 401(k) into an IRA.
- In doing so, you will have access to a much wider portfolio of assets.
- This is because IRAs are offered by online brokers.
- Your investment options may include thousands of US stocks, as well as index funds, bonds, and ETFs that track commodities.
Moreover, you will have the freedom to trade assets as you see fit with complete flexibility.
For example, if your 401(k) previously held an S&P 500 index fund, your IRA will enable you to exit the position and buy another asset.
This will not be subject to tax or penalties, as the capital remains in your IRA.
How does your 401k grow?
401(k) plans should be viewed as a long-term investment. The earlier that you start, the longer your retirement savings can grow.
You will also benefit from the impact of compounding growth by contributing to your 401(k) each and every month.
It is important to remember that while your savings will grow every time you make a contribution, you also need to consider the effects of market forces. After all, all investments go up and down. While many investments grow organically over the course of time, others don’t.
This is why most investment options in a 401(k) typically focus on index funds. This means that you will be investing in a broad range of assets, enabling you to reduce the risk through diversification.
Each index fund will come with its own risk and return, so you will need to choose carefully. For instance, if you are a young investor with 20-30 years ahead of you before you retire, you might consider investing in growth funds.
These are usually index funds that track small-caps or stocks based in emerging markets. As you grow older, you will likely want to reduce your risk exposure by investing in less volatile markets. Conservative options in a 401(k) often include index funds that track government bonds.
To offer some insight, the S&P 500 has grown by approximately 10% annually since its inception in 1957. This is based on reinvesting dividends every three months back into the fund.
In summary, I have revealed the ins and outs of how 401(k)s work. I have discussed the difference between traditional and Roth IRAs and explained the core factors surrounding contribution limits, withdrawal penalties, and required minimum distributions.
Ultimately, if your current employer offers a 401(k) plan, then it makes sense to start contributing to your retirement savings as early as possible. In doing so, you will be able to save for your golden years in a tax-efficient way.
What happens to 401(k) when you quit your job?
If you leave your current job, the best option is to transfer the 401(k) to your new employer. If your new employer doesn’t offer a 401(k), then you can roll it over to an IRA.
How do I find my 401(k) from an old job?
The easiest way to find an old 401(k) is to contact your old employer and ask for information. Once ascertained, you can then decide whether to transfer it to your current employer or roll it over to an IRA.
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