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Back to Basics: What Is a 401k?

May 09, 2019 · 4 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

Back to Basics: What Is a 401k?

Retirement seems like a lifetime away, but that doesn’t mean you can’t start planning for it now. Saving for retirement is one of the smartest investments you can make for your future. Your employer might offer a 401k along with matching contributions, but maybe you’re not sure if you can afford to take a chunk of money out of your paycheck, especially if you’re just starting out.

Beyond that, digging into the nitty-gritty of contribution limits, portfolio selection, withdrawal penalties, and opening a 401k account can be overwhelming. In this guide, we’ll break down all things 401k—how to get one and how to make it work for you

What Is a 401k?

A 401k is a feature of a qualified defined contribution plan that allows employees to contribute a portion of their wages to individual accounts.” In plain English, it simply means that you can participate in an employer-sponsored retirement savings account that both you and your employer can contribute to.

You can choose to have a certain amount from each paycheck go directly into your account. Many times your employer will match what you put in up to a certain amount. And 401k plans are available for entrepreneurs and solo business operators, following the same rules.

Where Did The 401k Come From?

The 401k is named for the section of the Internal Revenue Code that describes it. It was born just after Congress passed the Revenue Act of 1978, which made it possible for employers to start tax-advantaged savings accounts for employees.

The plan grew in popularity quickly, despite hesitation from the federal government, and by 1996 the combined assets of all 401k plans topped $1 trillion. Today, it’s the dominant form of retirement savings for American workers.

What Are the Biggest Benefits?

A 401k plan comes with many benefits for employees. First, contributions you make to your plan may reduce your taxable income, and that money will not be taxed until it’s distributed at retirement. Interest compounds over time, which can lead to significant growth. Because you can set up automatic deductions from your paycheck, you are more likely to save that money, instead of using it for immediate needs.

Another great benefit of having a 401k is that even though it’s set up through an employer, the money is yours. If you change jobs or cannot continue to work, you have the ability to roll the plan over into either your next employer’s 401k plan or another retirement account like an IRA.

What are the 401k Contribution Limits?

You’ll face two basic limits in contributing to your 401k—your personal contributions, and your employer’s. For 2019, the max 401k contribution is $19,000 . If you’re over 50, you can contribute an additional $6,000 as part of a “catch-up contribution.”

Growing Your 401k Investment

While setting up a retirement account is relatively straightforward, making sure it’s invested to match your risk tolerance is a bit more complicated. Your first decision is whether to set up a regular 401k or Roth 401k account, if your employer offers both options.

The big difference is in how they are taxed. A traditional 401k is taxed when you start to withdraw, at the tax bracket you’re in at that time. A Roth 401k is the opposite. You pay taxes on your income before making contributions to your Roth 401k. However, when you withdraw your money in retirement, it isn’t taxed.

As for investing your 401k contributions, more advanced strategy considerations involve diversifying your funds, how much risk you’re willing to take in the market, and how your 401k investments fit into your overall investment portfolio. For trusted advice, you may want to consult a wealth-management professional or financial advisor.

Withdrawals and Penalties

The basic principle of a 401k is that you are saving for retirement. Because of this, there are withdrawal requirements. When you turn 59 ½ you can begin withdrawing money without penalty, prior to this, you would pay a fee for withdrawing from your 401k. If you need to withdraw money from your 401k before you reach age 59½, you’ll have to pay an additional 10% early withdrawal penalty.

The best way to avoid withdrawal penalties is to keep your money in a 401k until you are 59 ½. When you begin to make withdrawals, you can do so either in lump-sum payments or in installments. If you have a traditional 401k, the money you contribute will be taxed when you withdraw it in retirement. At 70½, you’ll be required to start taking money out of your 401k or face some pretty big fees and penalties.

How Is a 401k Different From Other Retirement Accounts?

The other popular retirement savings account is the IRA. There are traditional and Roth options for IRAs as well. Similar to Roth versus traditional 401ks, Roth IRAs involve contributing after-tax income, whereas traditional IRAs tax your money when it’s withdrawn. While a 401k plan must be sponsored by your employer, anyone can open an IRA.

Contributions are limited to $6,000 a year, or $7,000 a year if you’re over 50, and there are income restrictions. The pre or post-tax deductions work similarly to a 401k, but another big difference is that you aren’t penalized if you don’t start withdrawing money at age 70½.

A Word about Tax-Reform Legislation

The Retirement Enhancement and Savings Act was introduced in the Senate in March of 2018 and is receiving bipartisan support. Among its provisions are rules to make it easier for small businesses to offer 401k plans, and ways for employees to contribute some of their tax returns into their 401ks.

Common 401k Mistakes to Avoid

Perhaps the biggest blunder you could make with a 401k is to not open one, especially if your employer offers a matching plan. Aim to contribute at least the same amount that your employer will match at 100%. Take the time to review a retirement calculator while determining your financial goals and making a financial plan.

Consider discussing your financial future with a professional to see how you can better prepare for retirement. Opening an investment account with SoFi gets you complimentary access to financial advisors who can help you determine your financial goals, diversify your investments, and help you manage your overall financial plan. You can even begin investing with as little as $100.

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External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
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The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.


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