Saving for retirement is one of the most important steps you can take to help secure your financial future. Your employer might offer a 401(k) retirement plan — and possibly matching contributions as well. However, if you’ve never signed up for a 401(k), you might be wondering whether you can afford to take a chunk of money out of your paycheck each pay period, especially if you’re just starting out in your career.
What is a 401(k) exactly and how does it work? Read on to learn about this retirement plan, including how to open and contribute to a 401(k) account, plus how it can help you save for retirement.
What Is a 401(k)?
A 401(k) is a retirement savings plan offered by an employer. You sign up for the plan at work, and your contributions to the 401(k), which may be a percentage of your pay or a predetermined amount, are automatically deducted from your paychecks.
You decide how to invest your 401(k) money by choosing from a number of available options, such as stocks, bonds, and mutual funds.
Employers may match what individual employees contribute to a 401(k) up to a certain amount, depending on the employer and the plan.
💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.
How Does a 401(k) Work?
The purpose of a 401(k) is to help individuals save for retirement. Once you sign up for the plan, your contributions are automatically deducted from your paychecks at an amount or percentage of your salary selected by you.
There are two main types of 401(k) plans. Your employer may offer both types or just one. The main difference between them has to do with the way the plans are taxed.
Traditional 401(k)
With a traditional 401(k), contributions are taken from your pay before taxes have been deducted. This means your taxable income is lowered for the year and you’ll pay less income tax. However, you’ll pay taxes on your contributions and earnings when you withdraw money from the plan in retirement.
Roth 401(k)
With a Roth 401(k), contributions to the plan are taken after taxes are deducted from your pay. Because your contributions are made with after-tax dollars, you don’t get an upfront tax deduction. The money in your Roth 401(k) grows tax-free and you don’t owe any taxes on the withdrawals you make in retirement — as long as you’ve had the account for at least five years.
Traditional 401(k) vs Roth 401(k)
Here’s a quick comparison of a traditional 401(k) and a Roth 401(k).
Traditional 401(k) | Roth 401(k) | |
---|---|---|
Taxes on contributions | Contributions are made with pre-tax dollars, which reduces taxable income for the year. | Contributions are made with after-tax dollars. There is no upfront tax deduction. |
Taxes on withdrawals | Money withdrawn in retirement is taxed as ordinary income. | Money is withdrawn tax-free in retirement as long as the account is at least five years old. |
Rules for withdrawals | Withdrawals taken in retirement are taxed. Withdrawals taken before age 59 ½ may also be subject to a 10% penalty. | Withdrawals in retirement are not taxed. However, withdrawals taken before age 59 ½ or if the account is less than five years old may be subject to a penalty and taxes. |
401(k) Contribution Limits
The amount an employee and an employer can contribute annually to a 401(k) is adjusted periodically for inflation. For 2024, the employee 401(k) contribution limit is $23,000. If you’re 50 or older, you can contribute an additional $7,500 as part of a catch-up contribution.
The overall limits on yearly contributions from both employer and employee combined for 2024 are $69,000. The limit is $76,500, including catch-up contributions, for those 50 and up.
How Does Employer Matching Work?
If your employer offers matching contributions, they will likely use a specific formula to determine the match. The match may be a set dollar amount or it can be based on a percentage of an employee’s contribution up to a certain portion of their total salary. For instance, some employers contribute $0.50 for every $1 an employee contributes up to 6% of their salary.
Employees typically need to contribute a certain minimum amount to their 401(k) in order to get the employer match.
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401(k) Withdrawal Rules
The rules for withdrawals from traditional and Roth 401(k)s stipulate that an individual must be at least 59 ½ to make qualified withdrawals and avoid paying a penalty. In addition, a Roth 401(k) must have been open for at least five years in order to avoid a penalty.
When you take qualified withdrawals from your 401(k) in retirement, you’ll be taxed or not depending on the type of 401(k) plan you have. With a traditional 401(k), you’ll pay taxes at your ordinary income tax rate on your contributions and earnings that accrued over time.
If you have a Roth 401(k), however, the qualified withdrawals you take in retirement will not be taxed as long as the account has been open for at least five years.
When you make withdrawals, you can do so either in lump-sum payments or in installments, or possibly as an annuity, depending on your company’s plan.
401(k) Early Withdrawal Rules
Withdrawals taken before an individual reaches age 59 ½ or if their Roth IRA has been open for less than five years, are subject to a 10% penalty as well as any taxes they may owe with a traditional IRA. However, an early withdrawal may be exempt from the penalty in certain circumstances, including:
• To buy or build a first home
• To pay for certain higher education expenses
• The account holder becomes disabled
• The account holder passes away and a beneficiary inherits the assets in their account
• To pay for certain medical expenses
Some 401(k) plans also allow for hardship withdrawals, but there are rules and expenses involved with doing so.
Required Minimum Distributions (RMDs)
If you have a traditional 401(K), you’ll be required to start taking money out of your account at age 73. This is known as a required minimum distribution (RMD) and you’ll need to take RMDs annually. Otherwise, you can face fees and penalties.
The amount of your RMD is calculated based on your life expectancy.
Pros and Cons of 401(k)s
A 401(k) plan comes with benefits for employees, but there are some downsides as well. Here are some of the advantages and disadvantages of a 401(k).
Pros
• Contributions you make to a traditional 401(k) plan may reduce your taxable income, and that money will not be taxed until it’s distributed at retirement.
• Contributions you make to a Roth 401(k) may be withdrawn tax-free in retirement.
• 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.
• Your employer may match your contributions up to a certain amount or percentage.
• The money is yours. If you change jobs or cannot continue to work, you have the ability to either roll over your 401(k) into an IRA or into your next employer’s 401(k) plan.
Cons
• Investment choices in a 401(k) may be limited. Your employer picks the investments you can choose from, and typically the selection is fairly small.
• You typically can’t make qualified withdrawals from a 401(k) before age 59 ½ without being subject to a penalty and taxes.
• You need to take RMDs from a 401(k)starting at age 73. Otherwise you may owe taxes and penalties.
The Takeaway
A 40I(k) plan is an employer-sponsored retirement savings plan that allows employees to contribute money directly from their paychecks. Plus, in many cases employers will match employee contributions up to a certain amount — meaning your retirement savings will grow faster than if you contributed on your own.
If you max out your 401(k) contributions, another option you might consider to help save for retirement is to open an IRA. Not only is it possible to have both a 401(k) and an IRA at the same time, but having more than one retirement plan may help you save even more money for your golden years.
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FAQ
Are 401(k)s Still Worth It?
It depends on your retirement goals, but a 401(k) can be worth it if it helps you save money for retirement. Contributions to the plan are automatic, which can make it easier to save. Also, your employer may contribute matching funds to your 401(k), and there may be potential tax benefits, depending on the type of 401(k) you have.
What happens to your 401(k) when you leave your job?
If you leave your job, you can roll over your 401(k) into your new employer’s 401(k) plan or another retirement account like an IRA. You can also typically leave your 401(k) with your former employer, but in that case, you can no longer contribute to it.
What happens to your 401(k) when you retire?
When you retire, you can start to withdraw money from your 401(k) without penalty as long as you are at least 59 ½. You will need to take annual required minimum distributions from the plan starting at age 73.
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