What is a 401k?
A 401(k) is a financial tool workers use to set aside a small part of the money earned each month. A 401(k) plan lets you reduce your taxes while saving for retirement.
The 401(k) is a powerful resource for achieving financial independence, especially when you start using it early in your career. Not only do you get tax-deferred gains but it's also hassle-free since contributions are automatically subtracted from your paycheck. In addition, many employers will match part of their employee's 401(k) contributions, effectively giving them a free boost to their retirement savings.
68%
Of American workers participate in a 401(k) plan
How does it work?
A 401(k) is a defined contribution plan. The employee and employer can make contributions to the account.
Employees also are responsible for choosing the specific investments within their 401(k) accounts from a selection that their employer offers.
With a traditional 401(k), employee contributions are deducted from gross income. This means the money comes from your paycheck before income taxes have been deducted. As a result, your taxable income is reduced by the total amount of contributions for the year and can be reported as a tax deduction for that tax year.
With a 401(k), you control how your money is invested. Most plans offer a spread of mutual funds composed of stocks, bonds, and money market investments.
No taxes are due on either the money contributed or the investment earnings until you withdraw the money, usually in retirement.
Employer Matching
Employers who match employee contributions use various formulas to calculate that match. For instance, an employer might match 50 cents for every dollar that the employee contributes, up to a certain percentage of salary.
Things to watch out for
While a 401(k)can help you save, it has plenty of restrictions and caveats. In most cases, you can't tap into your employer's contributions immediately. Vesting is the amount of time you must work for your company before gaining access to its payments to your 401(k). (Your payments, on the other hand, vest immediately.) It's an insurance against employees leaving early. On top of that, there are complex rules about when you can withdraw your money and costly penalties for pulling funds out before retirement age.
Getting your money out
The 401(k) is intended to be a retirement plan, so withdrawals are restricted in your younger years. There are a few exceptions, but most withdrawals before age 59 1/2 come with a 10% penalty.
Retirement withdrawals: You can start taking retirement withdrawals once you've reached age 59 1/2. You may be able to begin withdrawals at age 55 without penalty if you no longer work for the company. These withdrawals are taxed as ordinary income.
Required minimum distributions: If you don't need the money, you can leave it in the account until you are 72. In the first quarter of the year after you turn 72, the IRS requires you to take taxable withdrawals annually. These are known as required minimum distributions, or RMDs.
401(k) loan: Your plan may allow you to borrow against your 401(k) balance, which would not incur a penalty. You do pay interest on the loan; however, you’re paying interest to yourself. And, if you change jobs, you normally must repay the loan by the time your next tax return is due.
401(k) rollovers
Your job may not be a keeper, but your 401(k) balance is. If you change jobs, you can take your retirement money with you. Depending on your account balance, your former employer may even require you to take your funds out of the plan. Either way, you'll want to do what's called a 401(k) rollover so you can avoid any taxes or penalties.
