A 401(k) Can Help You Live Well in Retirement: Here Are the Details

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Even if you’re young, it’s never too early to think about saving for retirement. If you have a job that offers a 401(k) savings plan, enrolling and contributing money will put you on your way to building a nice nest egg.

Whether you’re just starting out or you’re already maxing out your 401(k) contributions — more on that in a minute — it’s helpful to understand how the plans work, what the rules are and your alternatives if your employer doesn’t offer a 401(k).

What Is a 401(k) and How Does it Work?

A 401(k) is an employer-sponsored investment plan designed to give you a tax break on your retirement investing.

The idea is that you, the employee, allot a certain amount of your paycheck to go straight into your 401(k). You can do this pre- or post-tax.

It’s up to you how much you want to put in, though the contribution limit as of 2020 is $19,500 of your own money per year.

Once you turn 50, you can make catch-up contributions of an additional $6,500 a year . Those catch-up contributions allow you to build your 401(k) even more as you get closer to retirement.

The best feature of a 401(k): Many employers will match your contributions up to a certain percentage.

Pro Tip

The cardinal rule of 401(k)s: If your employer offers a matching contribution, you should make the most of that free money and contribute at least up to the match.

What Does 401(k) Stand For?

The name 401(k) has no hidden meaning. It’s a section of the tax code introduced in 1978 designed to make it easier for employers to help their workers get in good financial shape for their retirement years.

The man behind the 401(k), Ted Benna, told Workforce he had no clue that it would become the main way people save for retirement some 40 years later. Yet, here we are.

Benefits of a 401(k)

While a 401(k) carries risks just like all investing, it’s an unequivocally smart move to contribute to one. It’s like paying yourself in retirement.

Here are some of the best perks.

Matching Contributions

One of the best things about a 401(k) is that many employers match your contribution.

Say your employer offers to match 100% of your 401(k) contributions up to 6% of your income. If you make $40,000 per year and max out the employer match, you’d put in $2,400 and your employer will kick in another $2,400.

Think of your employer’s match as a part of your compensation package.

You Can Automate Your Savings

A 401(k) is an easy way to save for retirement without realizing you’re doing it. The money automatically comes out of each paycheck, so you never miss it.

Since your employer is your 401(k) plan sponsor, the fees are usually less than if you set up a retirement account on your own. As with group rates on health insurance, your company can negotiate fees for things like mutual fund managers or financial advisers.

Upfront Tax Break

When you put money in a traditional 401(k), you’re deferring part of your salary until you retire. That means the money you contribute now doesn’t count as taxable income. You’ll pay taxes on it later on when you withdraw it.

401(k) Drawbacks

You also need to be aware of what you can’t do with a 401(k), and the rules governing contributions and withdrawals.

Limited Investment Options

A 401(k) typically has more limited investment options than other retirement accounts. You can’t pick individual stocks and bonds to invest in.

This is not necessarily a drawback if you’re unfamiliar with investing and are happy to have an expert do it for you. You’ll usually get several mutual funds to choose from, though more plans are starting to offer exchange-traded funds (ETFs).

A 401(k) isn’t a vehicle for playing the stock market, but rather for building wealth, based on your risk tolerance, over the long term.

Early Withdrawal Penalties

Because a 401(k) is meant to provide you income in retirement, there are penalties for withdrawing the funds early.

If you take money from your 401(k) before age 59 1/2, save a few exceptions such as becoming disabled, you’ll pay a 10% penalty and owe income taxes on what you take out. If you leave your job for any reason when you’re 55 or older, you can also avoid the 10% penalty on withdrawals from your current plan.

One important thing to note: The CARES Act allows coronavirus-related 401(k) withdrawals of up to $100,000 in 2020 with no penalty and allows you to spread the taxes over three years. Check with your employer, as not all plans offer this option.

Some plans also allow you to take what’s called a hardship withdrawal for situations like medical expenses or avoiding foreclosure, but it will be limited to the money you have put in. You can’t withdraw the earnings, and in most circumstances you’ll still be subject to that 10% penalty.

There are also certain circumstances for which you can borrow from your 401(k). But just like any other loan, you’ll have to repay it with interest. If you leave your job for any reason, you’ll have to pay it back in full when you file your tax return for the year. Otherwise, it will be treated as an early distribution, which means you get hit with taxes and the 10% penalty.

The bottom line: Don’t treat your 401(k) like a savings account. It’s important to have an emergency fund in addition to a retirement plan.

Vesting

You might come across the term “vesting” when signing up for your 401(k). This refers to how long you need to work for your company before you own all the funds in the account.

Say your company’s vesting schedule is two years. If you quit before that, you would forfeit the employer-contributed funds in the account, though any contributions you made would remain yours. That’s an incentive to stick around until you’re fully vested.

How Do 401(k) Taxes Work?

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Taxes for your 401(k) work in one of two ways. In a traditional 401(k), you make pretax contributions. With this type of account, you’ll pay taxes when you withdraw the funds after retirement.

Another option is a Roth 401(k), which approaches taxes slightly differently.

How Do 401(k) Taxes Work?

Taxes on your 401(k) work in one of two ways. In a traditional 401(k), you make pretax contributions. With this type of account, you’ll pay taxes when you withdraw the funds in retirement.

Another option is a Roth 401(k), which taxes the contributions you make. That means you withdraw the money tax-free upon retirement.

Traditional or Roth?

Before deciding between a traditional and a Roth 401(k), consider your current tax bracket and the one you expect to be in during retirement.

Most people will be in a lower tax bracket when they retire because their retirement income will be less than their salary while working. In this case, you might choose to stick with a traditional 401(k).

You might have the option to invest part of your money in a traditional 401(k) and part in a Roth 401(k). Check with your employer to see if this is possible.

Ultimately, the decision is yours, though it’s a good idea to speak with a financial adviser to determine what’s right for you.

What Happens to Your 401(k) When You Quit?

Since a 401(k) is an employer-based retirement plan, you’re probably wondering what happens to the money if you quit your job.

While your employer sponsors your account, it doesn’t own it. You own the account, and it’s often managed by a third-party administrator. If you quit or are fired, your money stays in the account. It will continue to grow and earn money, but you can’t make more contributions to it unless you roll over your 401(k) into a new employer’s plan or an individual retirement account.

Rolling over your old 401(k) into a new one is a seamless way to continue saving for retirement.

“For many people, having everything automated through their employer’s 401(k) plan is the only reason they have the discipline to save every month,” said Paul Ruedi Jr., a certified financial planner in Plano, Texas, who specializes in retirement planning.

If you roll it over into an IRA, you’ll be responsible for making contributions on your own. But remember, if your new employer offers a 401(k) with a matching percentage, you should strongly consider enrolling and contributing at least up to the match.

401(k) Investment Categories

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A 401(k) helps build your retirement savings by investing your money. You can choose to have complete control over where your money is invested or pick general categories and leave the decisions up to your broker.

Most 401(k) plans have four main investment categories.

Stocks

Your company’s 401(k) may allow you to invest in stocks. If this option is available, you’ll likely be able to purchase only company stock. Individual stocks may be an option if your plan has a broker.

Stock Mutual Funds

A stock mutual fund, which is a more common option, allows you to invest in a pre-set pool of  stocks rather than individual stocks for a more diverse portfolio with less risk.

Bond Mutual Funds

Similar to a stock mutual fund, a bond mutual fund allows investment in hundreds of bonds, which is less risky than investing in individual bonds.

Variable Annuities

Unlike stocks and bonds, annuities give out regular payments once you make an initial upfront investment.

The younger you are, the more risk you can afford to take with your investments. But if you’re nearing retirement age, riskier investments could result in you losing the money you need to live on.

The mix of investments you choose for your 401(k) is up to you, but you should take a few things into account, including your age. Stocks are riskier than bonds, so your 401(k) will likely be heavier with stock investments when you’re younger and switch over to higher bond investment as you get closer to retirement.

What if I Can’t Get a 401(k)?

While a 401(k) is a great benefit, not everyone is eligible. If your company doesn’t offer one, or if you’re an independent contractor, you can still save for retirement. The most common way is via an IRA.

Like 401(k) plans, you can choose between a traditional IRA or a Roth IRA. An IRA limits how much you can save per year. For 2020, the limit is $6,000. People 50 or older can contribute an additional $1,000.

Even if you have an employer-sponsored 401(k), you should still consider opening an IRA to supplement your retirement. To diversify the income you’ll have in retirement, consider contributing to your 401(k) at least up to the employer match, and then open a Roth IRA and put as much as you can in that. Then, when you’re withdrawing funds in retirement, you’ll owe taxes only on the distributions from your traditional 401(k). Remember, with a Roth, withdrawals are tax free.

Is a 401(k) a Good Idea?

That’s easy: Yes.

A 401(k) is an ideal first step to saving for retirement. If your employer offers one, look into maxing out the amount it will match, and consider contributing more money each month or opening an IRA too.

Your retired self will be endlessly grateful.

Catherine Hiles is a mother of two trying to balance retirement investment with child care costs and regular savings. She currently has a traditional 401(k), a Roth IRA and a sizable monthly day care payment.

Susan Jacobson, a former editor for The Penny Hoarder, contributed to this report.