Last Updated on November 14, 2023 by Ben
The 401(k) plan, invented in 1978 and has since grown to be the most widespread employer-sponsored retirement program in the United States, has evolved. Many employees count on the money they save through these plans to help them retire. A 401(k) approach is one of the most popular among businesses, and it provides flexibility to employees who want to balance their work and personal lives.
What is a 401(k) Plan?
The most common form of a 401(k) plan is an investment plan offered through an employer. Employees decide how their money will be invested, and an investment management firm, such as Fidelity Investments or Vanguard Group, oversees the money. The money grows tax-free, and the employees can withdraw it. Most plans also provide a match from the employer. The employer contributes a portion of each employee’s paycheck to the plan, and the employer will match that contribution up to a certain number of percentage points.
How is a 401(k) Different from an IRA?
A 401(k) plan is a kind of qualified plan. Like the 401(k), a type of qualified plan called an IRA is offered through an employer. However, an employer doesn’t have to offer a 401(k), nor must an employee participate in one. A 401(k) is not an individual retirement account. The worker makes the contributions to an IRA, and the earnings on those investments grow tax-free until the person begins to withdraw them. A 401(k) does not have an age limit on contributions.
However, once you reach age 50, you can only contribute a limited amount to your 401(k) per year. You don’t need to worry about a 10% early-withdrawal penalty. With a 401(k), the balance you have at age 70 is what you start with at retirement age. You don’t have to pay any tax on this amount at retirement. Also, you will have more control over how your money is invested than you would with an IRA.
Automatic payroll deductions are the most common way to contribute to your 401(k) plan. However, some employers give you the option of making a lump-sum contribution at the beginning of the year. Generally, the employer match is included in calculating your overall contribution.
Make sure you know the plan’s limits on contributions before you decide to contribute. Generally, you must be at least 21 years of age to contribute to a 401(k). However, your employer may offer you a 401(k) if you are younger. Some employers offer their employees a 401(k) at no cost to themselves if they work a certain number of hours per year.
Investing in a 401(k)
When you invest your 401(k), you have the opportunity to choose among a variety of investment options. Each option has a risk profile that you will want to consider. You can choose to invest your money in a target-date fund, and these funds have a set date after which they cannot be held. You can also choose to invest by choosing a variety of stock and bond funds. One option is to create your investment portfolio, which may include a mix of the available funds.
Withdrawing Funds From Your 401(k)
- How do 401(k) require minimum distributions (RMDs) work?
When you reach age 70 ½, you generally must take RMDs from your 401(k). Although these distributions are required by law, they can be delayed or stopped by the employer in certain circumstances. Your RMDs are calculated using default rules, but you have some control over when they begin. Your RMDs are taken out of your account over as little as five years, or as many as 40 years. The exact timing is based on your age when you started contributing to the plan.
- How to avoid 401(k) early withdrawal penalties?
The Internal Revenue Service (IRS) has rules regarding what must be done when you withdraw from your 401(k) before 59 ½. Generally, you’ll avoid an early withdrawal penalty by using at least a portion of your 401(k) to pay for your retirement. The penalty is 10% of the balance you withdraw. You can also minimize the penalty by making pretax contributions to your 401(k) and waiting until age 70 to take your RMDs.
What Happens to Your 401(k) When You Change Jobs?
- Leave your 401(k) with your old employer
Your old employer should provide you with a form to fill out to help your new employer find your 401(k) plan. You should review this form and give it back to your former employer.
- Move your 401(k) into your new employer’s plan
You might have the option of moving your 401(k) into your new employer’s plan, reducing your risk of having your money tied up in your old employer’s plan. You also may qualify for more investment options with your new employer’s plan, such as their own choice of investments.
- Roll your 401(k) balance into IRA funds
Your new employer might also offer to help you roll over your 401(k) into an IRA. That would move your balance from your employer’s plan to an individual retirement account. You wouldn’t have to pay tax on the money right away, and it grows tax-free until you take withdrawals in retirement.
Final Thoughts – 401k Basics
Your money is held in an IRA, an individual retirement account at retirement. You don’t pay tax on that money because you still are working, and the money in an IRA can grow tax-free. Finally, with a 401(k), you make contributions to the plan you’ve chosen to work for. These are matched by your employer, so your contributions are doubled (up to a maximum of a few thousand dollars). Once you reach retirement age, you begin receiving a mandatory retirement distribution from your 401(k) plan.