A Beginners Guide to 401(k)s

With a 401k, time is on your side. If you’re ready to collect tax-free money that will only grow over time (and why wouldn’t you be?), it’s time to look into 401(k)s today.

When an employer sponsors a 401(k) plan, all employees legally have an equal opportunity to save for retirement. But not all plans will be the same. Some will have more restrictions, others will come with heftier fees. So it’s important to know what you’re signing up for (or what your employer has automatically signed you up for) going in.

For those ready to get started, here’s what to know about 401(k)s.

What is a 401(k)?

A 401k is an employee-sponsored retirement savings plan. With a 401(k), employees are able to save and invest a portion of their salary in a tax-free manner. That set-aside portion goes directly into their pension account and grows over time. Taxes only have to be paid once the money is withdrawn.

One of the best aspects of a 401(k) is that it’s a largely self-directed account. You’re able to control how your money is contributed, invested, and reinvested. Typically, employers will provide a list of investments your specific plan offers. As noted by Finra, when you sign on for a traditional 401(k) plan, “the taxable salary that your employer reports to the IRS is reduced by the amount that you defer to your account.”

How Much Do You Put In?

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Generally speaking, you should put in as much as possible. However, take into account how much you’ll need to live on and pay down any standing debt you have. If possible, you should always invest enough to reach the full amount your company puts in to match your contributions. Otherwise, you might be throwing away free money.

The majority of plans offer matching funds. One of the most popular plans offers 3% of your salary and financial experts often recommend contributing the maximum amount annually, or as close to it as financially possible and realistic.

As of 2021, the cap for employee contribution is $19,500 but it’s also possible your employer may contribute less. For anyone over 50 years old, the maximum amount goes up so the employee has a chance to “catch up” prior to retirement. Currently, those who meet that age requirement can contribute up to an additional $6,500 each year.

401k Benefits

Obviously, the main benefit of having a 401k comes down to financial security. But let’s unpack that a little. First, there’s the chance for free money. And it’s free money that can keep growing on its own. As mentioned, many employers will match their employees’ contributions within the designated limit. For instance, a company may offer to match either a dollar for dollar or 50 cents to the dollar. But again, the amount is not set or guaranteed. Ultimately, it’s your employer’s decision what percentage they decide to match. In most cases, companies will offer a dollar-for-dollar match.

No matter your 401k situation, tax breaks are definite for those who invest. With these special retirement accounts, contributions are pre-tax and that can go a long way. Since 401k contributions are not considered income, having a 401k could potentially place you in a lower tax bracket down the line. Thirdly, your completely tax-free money will grow over time. The only requirement is that the funds stay in the plan. This way, your earnings will be able to compound. On top of that, no matter how many times you sell investments that have been increasing in value, no capital gains tax will be owed on any of the profits. So while there will likely be transaction fees, you can reinvest the entire accrued amount eventually.

Ready for more good news? This tax-free, accumulating money is also safe from creditors. Let’s say you find yourself in a not-so-great financial situation unexpectedly. You won’t have to worry about what will happen to all of the money you’ve been putting away in your 401(k). Creditors won’t be able to touch any of it. One of the best things about this qualified retirement plan is that it is fully protected by the Employee Retirement Income Security Act of 1974 (ERISA).

But as with most savings plans, 401(k)s come with their own set of restrictions.

401k Restrictions

For most interested in opening a 401(k), it’s not difficult to qualify. However, employers can impose two restrictions out the gate. Firstly, you must work for a full year (typically that comes to 1,000 hours over a 12 month period). Secondly, employers may require their employees to be at least 21 years old to be eligible for enrollment. However, not all employers abide by these rules. When entering a new job situation, it’s important to inquire about when you’ll actually be able to start contributing to your 401(k) with these potential restrictions in mind.

In addition to eligibility restrictions, those who qualify don’t have immediate access to their employer’s contributions. This comes down to vesting. Vesting is the amount of time an employee is required to work before gaining legal access to 401(k) payments made by their employer. Any and all money you’ve contributed to a salary-deferral plan completely belongs to you. Still, to access those funds sooner rather than later, you’d typically have to change jobs or retire in order to withdraw or move that money elsewhere.

When it comes to employer contributions, you don’t have legal access to the money they’ve put in (or earnings from those contributions) until you are fully vested. Simply put, vesting is entirely determined by time on the job. In addition to vesting, there are a variety of rules about when the money can be withdrawn your money you should definitely know.

Rules For Withdrawing

If funds are taken out before retirement, there will almost always be costly penalties. An early withdrawal of assets will mean income taxes are due. In most cases, a 10% tax penalty will be enforced for anyone under 59, and it will affect all of the funds.

There are also restrictions regarding what goes in. While it is often advised that you invest a significant portion of your salary (if and when possible), all 401(k)s have an annual limit. Your employer may match what you put in within that limit, but not necessarily. On top of that, there are contribution limits for higher earners. As noted by Investopedia, the contribution limits for most people tend to be high enough that they allow adequate levels of income deferral.

According to the IRS, distributions of elective deferrals can’t be made until one of the following occurs:

  • The account holder dies, becomes disabled, or has a significant severance from employment.
  • The active 401k plan terminates and no successor contribution plan is established or maintained.
  • The account holder reaches 59½ years old.
  • The account holder experiences a financial hardship that leads to an immediate and heavy financial need.

Depending on the terms of the plan, distributions may be made on a nonperiodic basis, such as lump-sum distributions, or periodically, such as installment payments or annuity.

What is a 401k Rollover?

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There may come a time when you change jobs or no longer wish to work for the company you opened your 401(k) with. A 401(k) rollover allows you to transfer your funds from your original employer to an IRA (individual retirement account). You can also move the money into a 401k plan with your new employer.

If neither of these options is appealing, there is also the option to cash out your 401k funds. But keep in mind, an early cashout like this would always come with huge and unavoidable penalties (including immediate income tax and an added 10% withholding fee.)

There may also come a time where the company you work for is in trouble or not financially stabilized. But don’t worry. No matter the fate of your employer, your 401(k) will remain off-limits. If your company winds up going under, chances are the plan would be terminated. So be prepared for the next step. Financial experts advise rolling the 401(k) money over into a traditional IRA. This way, you’ll be able to avoid paying the income taxes and 10% withdrawal penalty.

How to Set Up Your 401(k)

If your employer hasn’t already done it for you, the first step is signing up. Many companies automatically enroll you, and it’s worth looking into if you’re not sure. Again, some companies will have a waiting period before you’re eligible to enroll. Once you’re enrolled in any plan, you’ll be allowed to make adjustments to your investment choices and level of participation within the 401(k) at any time that suits you.

Next, you’ll need to select the account type that works for you. In recent years, the options have been expanding. Typically, traditional 401(k)s are the standard plan in most workplaces. However, more employers have begun incorporating the Roth 401(k) as an option as well.

Also, be sure to go over the investment options of each available plan and leave no stone unturned. You’ll want to know the ins and outs of the investment fees you’ll be agreeing to. As noted by NerdWallet, if you review just one aspect of your company’s 401(k) options, make it the investment fees (often called “management fees” or “expense ratios”).

With 401(k)s, there’s always the chance to receive free money in one way or another. When calculating what you’ll contribute, aim to put in the bare minimum of what your employer will match, and take the vesting period into account. Again, whatever you contribute will be yours to keep no matter what happens. To get the most value out of the tax-free growth of those funds, investing will be vital.

Supplement Your Savings With The Future in Mind

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The IRS allows workers to set up and save in more than one type of tax-favored accounts simultaneously. And it’s something worth serious consideration. Combining a 401(k) and an IRA can potentially increase your tax savings exponentially and significantly contribute to your financial freedoms. Not to mention, IRAs tend to offer significantly more flexibility and personal control over investment options and fees.

While notably different, 401(k)s and IRAs are the two main types of retirement accounts. If you’re planning to look into your 401(k) options, IRAs should be looked at as part of the total package. With the power of these accounts combined, you’ll get the most out of what you contribute in the long run.

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