Whether you want to enjoy a quiet life on the beach or travel around the world to exotic locations, one thing is certain: Retirement will most certainly be the most expensive item you ever spend money on.
Unlike other major life expenditures (cars, houses, and education), there are no loans for retirement. That implies you’ll have to put money aside.
A 401(k) is a type of retirement savings plan that you may set up at work if your employer offers one, and it’s designed to help you save for retirement. Here are the basics on 401(k)s.
What Is a 401(k) and Why Is It Called a 401(k)?
A 401(k) is a defined-contribution retirement savings plan that is sponsored by your employer. A 401(k) is, in other words, a perk provided to employees through payroll contributions that they can use toward their own retirement. Because of Internal Revenue Code section 401(k), companies were able to establish employee retirement plans.
What is the origin of the term “401(k)”? Despite their tremendous popularity nowadays, 401(k) plans were essentially created by accident. In 1978, Congress passed the Revenue Act, which allowed employees to avoid being taxed on deferred compensation. This was done through a provision that was added to the Internal Revenue Code, called Section 401(k).
Ted Benna, a benefits consultant for a client in 1980, referred to Section 401(k) while researching ways to create more tax-friendly retirement plans. He came up with the concept of allowing workers to contribute pre-tax money to a retirement account and getting an employer match. Benna’s employer rejected the concept, so Benna’s own business, The Johnson Companies, was the first to offer its staff a 401(k) plan.
The IRS passed new regulations in 1981 that permitted staff to contribute to their 401(k) through payroll deductions, which fueled the popularity of the plan. According to the Employee Benefits Research Institute, nearly half of all large corporations were providing 401(k)s or considering them within two years.
How Does a 401(k) Work?
A 401(k) plan, like other tax-advantaged retirement savings accounts, is structured similarly. However, distinct features, advantages, and restrictions for 401(k) plan set them apart from other retirement account types. The contribution restrictions, withdrawal conditions, and potential for employer matching contributions distinguish 401(k) plans from other retirement savings.
Employees who are eligible for a 401(k) can choose to make voluntary contributions toward their retirement. Employees can also pick how to invest their funds by selecting from a list of preapproved investment options, which are commonly mutual funds.
Features, Benefits, and Rules for 401(k)
⦿ Who Can Contribute to a 401(k)
The only way to add money to a 401(k) is if you work for an employer that offers this retirement plan benefit.
⦿ Eligibility Requirements
Not everyone can contribute to a 401(k) plan. Employees who are age 18 or older and full-time are the typical limitations. Many plans have a minimum age of 21 and a 12-month waiting period before employees may join the plan and make contributions.
⦿ Contributions and Limits
Employees who are eligible may make voluntary contributions, referred to as salary deferrals, which are usually a percentage of salary that is withheld and transferred into the employer’s sponsored plan.
The IRS sets the maximum taxable year 2022 401(k) contribution at $20,500. Employees who are at above 50 years old by the end of the year can make “catch up contributions” of up to an additional $6,500 per year as of 2022.
⦿ Traditional and Roth 401(k) Contribution Types
A participant can make traditional pre-tax contributions (also known as “Roth” after-tax contributions) or a mix of both kinds if they are held in separate accounts as long as the overall amount does not exceed the yearly maximum.
⦿ Investment Choices
Most 401(k) plans provide at least ten to twelve, and often up to thirty, investment alternatives, which usually include a wide range of mutual funds. Many plans also feature target-date retirement funds.
⦿ Employer Matching Contributions
Employer matching contributions, which are often governed by a formula such as a maximum of 50% of employee deferrals and up to 6% of compensation, yielding a 3% match, are possible.
⦿ Making Withdrawals from a 401(k)
Withdrawals are generally not allowed until the end of employment or retirement, though in-service withdrawals for compelling personal reasons may be authorized.
⦿ 401(k) Tax Benefits
The earnings on your 401(k) contributions are tax-free. Traditional contributions to a 401(k) are built on a pre-tax basis, which means they lessen taxable income for the year of contribution. Traditional 401(k) withdrawals are taxed as earnings. After age 59 1/2, Roth contributions may be withdrawable without taxes.
Important: While the Department of Labor and IRS need all 401(k) plans to follow certain rules and requirements, not all plans work alike.
For instance, all 401(k) plans have the same maximum contribution limits and share the same tax and penalty rules for withdrawals. But some features and benefits, such as parallel employer contributions and personal loans, are not legally needed to be presented in the plan.
How Much Can You Give to a 401(k)?
The maximum annual 401(k) contribution for 2022 is $20,500. Individuals age 50 or older may contribute an extra $6,500 in the form of a “catch up” allowance, bringing the total to $27,000. Remember that the yearly maximum does not include any matching contributions you may get from your employer.
⦿ Are 401(k) Contributions Pre-Tax?
The 401(k) participant makes pre-tax contributions, but only if they choose to contribute in a traditional manner. If the participant opts for Roth contributions, they are made on an after-tax basis.
⦿ How Does a 401(k) Match Work?
Employers frequently offer 401(k) matching contributions to their workers. You won’t get a 401(k) match from your employer unless you make your own contributions first, as the term implies. The amount of the match is usually determined by a formula.
A typical matching program offers 50 cents for each dollar you put in, up to 6% of your compensated income. This implies that if you contribute at least 6% of your gross pay, your employer will match half of the amount, which would be 3% of your gross payment.
⦿ What Does It Mean to be endow in a 401(k)?
Being vested in a 401(k) means that you own the money in it. This means that you have control over what happens to it and can make decisions about it. For example, you may own 100% of your own contributions but must work for a specific number of years to be fully vested in employer contributions, such as the match.
If, for example, your employer’s 401(k) vesting schedule for the match is 25% per year, and you quit after two years, you have a legal right to take with you 50% of the employer matching funds contributed during that time, plus 100 percent of your own contributions, as well as any growth on those investments.
e presented in the plan.
When Can You Pull out From a 401(k)?
The procedures for withdrawing funds from a 401(k) plan are quite complicated. While these restrictions may differ from plan to plan, participants in 401(k) plans may withdraw money for four primary reasons:
2. Termination of employment
4. Hardship withdrawal
At What Age Can You Pull Out from a 401(k)?
At age 59 1/2, you can take money out of your 401(k) without paying the IRS-mandated 10% “early withdrawal” penalty. You may make withdrawals before age 59 1/2 under specific conditions, but you will have to pay the 10% penalty and any applicable taxes.
What is the Sanction for Withdrawing from a 401(k) Early?
There are restrictions on withdrawing money from a 401(k) account. You can withdraw money without penalty beginning at age 59 ½, but you would have to pay a fee to withdraw from your 401(k) earlier than that. If you withdraw money from your 401(k) before you reach the age of 59½, you may have to pay the penalty. This is called the 10% early withdrawal penalty.
To avoid withdrawal penalties, keep your money in a 401(k) until you are 59 ½. You can choose to take the money out in one lump sum or in installments. If you have a traditional 401(k), the government will tax the money you take out when you retire. When you turn 72, you will have to start taking money out of your 401(k). This is called a required minimum distribution. If you don’t take the money out, you will have to pay fees and penalties.
What Is a Traditional 401(k) vs. a Roth 401(k)?
Traditional and Roth are two variants of 401(k) contributions. With both types, the money grows without being taxed. The two main types of 401(k) plans are the traditional 401(k) and the Roth 401(k). The way contributions are made, and tax paid on withdrawals are different between the two types.
How a Traditional 401(k) Works
- Traditional 401(k) contributions: A 401(k) is a savings account that reduces the amount of taxes you have to pay.
- Traditional 401(k) withdrawals: taxed as income, which is taxed at the individual’s topmost federal tax rate.
How a Roth 401(k) Works
- Roth 401(k) contributions: form on an after-tax basis.
- Roth 401(k) withdrawals: tax-free to the individual if made after age 59 1/2.
What Occurs to Your 401(k) If You Quit Your Job?
There are some things you can do with the money in your 401k plan when you leave your job. You can take the money out, transfer it to a new retirement plan, or leave it in the old plan – as long as certain conditions are met.
There are a few choices you have to make with your 401(k) when you leave your job.
⦿ Cash Out Your 401(k)
If you are old enough to take out your 401(k) funds without penalty, you may choose to do that when you leave your job. Once you become 59 1/2, any money in a retirement plan is yours to access without penalty. You can use your 401(k) from your most recent job to tap into if you are 55 years old or older. There is no penalty for doing this.
But prior to you cashing out your old 401(k), consider whether you really need that money right now. If you don’t, leaving your money in a tax-advantaged retirement plan will mean that you can enjoy more years of tax-deferred or tax-free growth, depending on whether you have a traditional 401(k) or a Roth. If you possess a big balance in your traditional 401(k), cashing it out will result in you having to pay taxes on that money. The bill could be very large.
No matter why you left your job, it is important to think carefully about what you will do with your 401(k). If you are many years aside from retirement, rolling the money into a new IRA or 401(k) is usually your best option. But either way, it is a good idea to have a game plan before your resignation becomes official.
⦿ Rollover to Another Retirement Account
If you have switched jobs, find out if your new employer offers a 401(k) plan. If they do, see if you are eligible to join and if the plan allows rollovers from your old job’s 401(k) plan. Some employers require new employees to work for a certain number of days before they can register for a retirement savings plan. Make sure that your current 401(k) account is ready to go before you roll over your old account. This means that your new account will be active and able to receive contributions.
Once you enroll in a 401(k) plan with your new employer, it’s easy to roll over your old 401(k). You can choose the administrator of your old plan to deposit the balance of your account directly into the new plan. All you have to do is fill up some paperwork. This is when you transfer your money from one custodian to another. This way, you don’t have to worry about any taxes or missing a deadline.
You can also choose to have the money from your old account sent to you as a check. This is called an indirect rollover. You have to deposit the money into your new 401(k) within 60 days to avoid paying income tax on the whole balance and an additional 10% penalty for early withdrawal if you’re younger than age 59½. When you do an indirect rollover, your old employer is required to withhold 20% of the money for federal income tax purposes. This means you might not get to keep as much money as you expected.
⦿ Leave the Money in Your 401(k)
If you have more than $5,000 in your 401(k), your plan might allow you to leave the money in the account after you leave your job. “If it is less than $1,000, the company can force out the money by issuing you a check,” says Bonnie Yam. Yam is a Certified Exit Planning Advisor for Pension Maxima Investment Advisory Inc. in White Plains, N.Y. If your company forces you to leave and you are getting a severance package of $1,000-$5,000, the company must help you set up an IRA so that you can keep the money.
Leaving your 401(k) with your old employer may be a good idea if you have saved a lot of money and like the investment plan. If you are probably to forget about the account or are not impressed with the investment options or fees, consider some of the other options.
Pros and Cons of Having a 401(k) Account
A 401(k) plan is a way to save for retirement. This type of plan has some good things about it and some bad things. You should think about whether a 401(k) is the best way for you to save for retirement before you decide to sign up.
Pros of Having a 401(k) Account
⦿ Simplicity: Once you sign up, you choose how much money you want to contribute each pay period. You then select what investments you want your money to go into. Contributions are automatically made through payroll on a periodic basis. This process is very easy and doesn’t require a lot of maintenance from you.
⦿ Transferrable: If you leave your job, you can choose to move your 401(k) into an IRA or to your new employer’s 401(k) plan without any tax consequences.
⦿ Tax advantages: 401(k) accounts grow without taxes, and traditional pre-tax contributions reduce how much money you pay in taxes.
⦿ Dollar-cost averaging: 401(k) contributions are made over time. This way, it is easier to afford the investments, and it also reduces the risk that comes with investing in the stock market.
⦿ Compound interest: When you invest money in a 401(k), the interest, dividends, and capital gains all stay in the account and help it grow faster over time than typical deposit accounts.
⦿ High maximum contribution: The most you can contribute to a 401(k) plan in 2022 is $20,500. The most you can contribute to an IRA in 2022 is $6,000.
⦿ Shelter from creditors: The Employee Retirement Income Security Act, or ERISA, protects 401(k) accounts from being taken away by creditors.
⦿ Possibility of employer contributions: If your employer matches your contributions, that is like getting a bonus on top of the money you save. Plus, the interest on your savings will grow even faster!
⦿ Access to money for hardship: If you are having financial difficulty, you may be able to get a hardship distribution from your 401(k) plan. Some 401(k) plans offer loans.
Cons of Having a 401(k) Account
⦿ Limited investment selection: 401(k) participants can only choose from a set of pre-selected investments.
⦿ Lack of control over your account: Even though your vested account balance belongs to you, 401(k) plans do not allow you to take the money out at any time for any reason.
⦿ Potential for high fees: Some plans have administrative fees and investment costs that are higher than accounts, such as IRAs, that people can open and manage on their own.
⦿ Early withdrawal penalty: If you withdraw money from your account before you turn 59 and a half, the IRS will charge you a 10% penalty.
A 401(k) account is a great way to save for retirement. You can choose to contribute a portion of your salary, and your employer may even match your contributions. The money you save grows over time and provides you with income in retirement. If you’re not already taking advantage of this savings opportunity, be sure to check into enrolling in a 401(k) plan today!