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Quick Answer: A 401K is a retirement savings plan that you can get through your employer or job. The advantage of investing your money into a 401K is that you do not have to pay taxes on the money you put it. You will only pay taxes on your money when you withdraw the money. You can contribute $19,500 per year. There is also an additional catch up contribution for folks who are 50 and over. Some employers will match your contributions up to a certain percentage. This is usually outlined in your employee handbook or can be verified through your HR department.
The 401k is an amazing way to save for retirement. There is a reason most Americans contribute their nest egg into a 401K. Not only does your employer most likely match a percentage of your contributions (AKA free money) it also has tremendous tax benefits. If you are new to the 401k, consider its benefits to see if it is the right investment vehicle for you.
What Is a 401K?
The 401k plan is a special type of retirement savings account for employees that allows them to divert a certain portion of their salary into long-term investments. It is funded through pre-tax payroll deductions combined with a ‘defined contribution’ from the employer to match the amount invested by the employee up to a limit.
To put it simply, you can invest your hard-earned dollars into a 401k, without having to pay taxes on the money you deposit. Sweet deal right?
The 401k retirement saving vehicle falls under the category of ‘qualified’ retirement plans. This means that the account holder can receive special tax benefits under the guidelines set by the IRS.
It was first introduced by Congress in 1981 and to date, remains one of the most widely followed retirement savings models because of the versatile investment options that it offers.
For example, employers can invest the funds in their 401k accounts in mutual funds, stocks, bonds, and other assets, to name a few. They will not be liable to pay taxes on any of dividends, interest, or capital gain from their investment unless they wish to withdraw their savings.
It’s called a ‘401k’ because that is the section of the Internal Revenue Code that defines it at length.
There are two different types of 401k plans: traditional 401k and Roth 401k. Although they work pretty much the same way, the difference lies in taxation.
In the traditional plan, your contributions are not taxed but your withdrawals will be.
The opposite is true for the Roth 401k. You will be taxed on money going in but will not be taxed when you withdraw.
What Are the 401K Maximum Contribution Limits?
The max contribution limits have been rising year over year. As of this year, the maximum contribution limit is $19,500 whereas the maximum catch-up limit is $6,500. The catchup limit is for those over the age of 50.
The contribution limits depend on the type of plan that you choose. It is also influenced by factors such as government guidelines and the amount of money that you earn in the first place.
Generally, your employer or organizational policies will determine the maximum contribution limit for your plan. This will be expressed as the percentage of salary that you can divert towards retirement savings. You will be informed about the limit at the time of agreement.
For instance, if you are allowed to contribute 5% of your salary and you earn $20,000 pre-tax, the maximum contribution limit for your 401k will be $1,000.
Given the rising cost of living in the last decade, the government has increased the maximum contribution limit for 401k plan by $500 every year since 2010.
What is the Catch-Up contribution?
For employees over 50 years of age, the employer might also offer what is known as the ‘catch-up’ contribution. This lets you save an additional amount ($6,500 per year) of money apart from the defined deductions from your salary.
The catch-up contribution is fantastic for those who did not start their nest egg early in life and is highly recommended for anyone who is eligible.
This is for good reason. Your tax rate is much higher in your working years (because you are earning income) than it is in your retirement years (because you are not earning income).
What Are the Tax Advantages of a 401K?
The 401k plan is one of the easiest ways to start saving for your retirement. But what makes it more popular among people is perhaps the favorable tax treatment.
Since the capital gains, interest, and dividends, on these investments are not taxed until disbursement, they accumulate tax-deferred over time.
If you have a considerably long way to go until retirement a 401k should definitely be considered. The tax advantages of a 401k can make a world of difference between struggling through your golden years or enjoying them comfortably.
To get a better idea of the tax benefits of this plan, consider the fact that you fund your savings account with ‘pretax’ dollars. In other words, a 401k lowers the amount of income on which you are required to pay taxes. This not only softens the blow on your take-home salary for every month but also lowers your overall tax bill in the long run. Meaning you give away less of your hard-earned dollars to uncle sam.
What Is 401k Vesting and How Does It Work?
401k vesting, also known as your vested balance, is the amount of money in your retirement savings account that you are allowed to take with you in case you decide to leave your current job.
It also signifies your maximum borrowing limit if you want to take a 401k loan.
The way vesting works is quite simple and straightforward, though it tends to throw people off track.
The money you put into your 401k account is always 100% yours. However, in order to claim the contributions made by your employer, you must be fully, or at least partially, vested. Depending on your company’s rules and regulations, becoming fully vested in your account can take anywhere between three to six years.
There are two main types of vesting schedules followed in most organizations:
- Cliff Vesting: As per this schedule, you cannot claim your employer’s contribution unless you have for them for at least three years. After that, you have full ownership of all the money in your 401k account.
- Graded Vesting: Under this schedule, you get to become fully vested after six years of service in the same place. Each year, your ownership grows by 20%. So, for instance, if you leave after working for only one year, you can only claim 20% of what your employer contributed over that time period.
If you wish to change jobs, don’t forget to check your vested account balance first. Based on your plan, staying a little longer can add a handsome amount of money to your 401k savings.
When Can You Withdraw Your Money from a 401K?
One of the golden rules of personal finance is do not touch your 401k.
If you withdraw money from your 401k account before the age of 59 ½, you will have to pay a 10% early withdrawal penalty (BOOOO). Since these funds come from your pre-tax salary, you will also have to pay income tax on the amount that you cash out.
For example, let’s say you fall in the 24% tax bracket and wish to withdraw say $5,000 from your 401k. You will have to pay a total of $1,700 in penalties and taxes. So, always think twice before withdrawing money from your retirement plan.
If you are switching jobs, it would be wise to let your investments rollover to an IRA rather than cashing it out before you leave.
How to Roll Over your 401K to an IRA
If you leave your employer want to roll over your 401k to an IRA. The best thing to do is first choose the brokerage you would like to use.
Then you open a rollover IRA. Any brokerage can do this from Vanguard, Fidelity, Charles Schwab, and TD Ameritrade.
That term seems overwhelming. You can call your new brokerage directly and they can help walk you through the steps. This is a much better option than taking the money out of your 401k because you will get hammered with a 10% penalty and taxes.
How Much Should You Contribute to Your 401K?
If you can, stuff as much money as you can into your 401k. Aim to hit the maximum contribution every year. The more money you can defer from taxes the better.
If you are just starting out, the first thing to do is make sure you at least get your employers match. For example, If your employer matches the first 5% of the money you contribute, it would be stupid not to contribute 5% of your salary.
Why? Because it is free money. You are leaving money on the table by not taking this contribution.
Aim to contribute at least 10% of your income in your 401K and 10% of your income in a Roth IRA.
Andrew is the host of The Personal Finance Podcast, a show that is changing the way you think about your money. His primary goal with the podcast is to bring as much value as possible to his listeners.
Andrew's favorite free financial tool he's been using since 2014 to manage his net worth is Personal Capital. Each month he uses their free Investment Checkup tool and Retirement Planner to track his investments and ensure that he's on the fast track to financial freedom.
His favorite investment platform is M1 Finance, a site that allows him to build a custom portfolio of stocks for free. It has no trading fees and is his preferred way to invest without having to lift a finger.
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