No one needs to remind you that you should save for retirement. After all, no matter your age and how far away your retirement is, you want to enjoy your golden years without having to worry about money.
In the past, many employees could depend on a traditional pension from their employer. But that was then. With traditional pensions becoming a rarity, we are pressured to do the heavy lifting of saving for retirement on our own. Although the word ‘401k’ is synonymous with retirement planning, how many of us know and understand all the rules of a 401k plan?
Here is a guide to understanding a 401(k) plan:
What is a 401k and why enroll in a 401k plan?
The 401k plans are retirement plans offered by employers. And a 401k account is tied to your employer because the employer sponsors the plan. A 401k is just the name of your retirement savings account where you save money for retirement.
A 401k account is a tax-deferred retirement account. It allows you as an employee to set aside a percentage of your pre-tax earned income to a retirement account.
When you set aside your pre-tax money you avoid paying taxes on that income today and allow those contributions to grow tax-free until retirement. But when you retire and start withdrawing money from your 401k account you will have to pay taxes on your withdrawals.
Why enroll in a 401k plan?
The best benefit of the plan is to reduce paying taxes today and allow your contributions to grow tax-free for a long time.
However, you cannot avoid paying taxes entirely. You will pay income tax on any money you withdraw from your 401k when you retire.
How to open a 401k account?
Opening a 401k account is pretty simple. You can open an account when you do your paperwork as a new employee. However, you are not required to start the 401k when you are first hired. It can happen at any time. You just need to fill out the paperwork and decide how much of your paycheck will be going into that account. Your contributions will be automatically deducted from your paycheck.
How much can you contribute to a 401k plan?
Retirement savings accounts are regulated by the IRS. That means the IRS sets the rules as who can use a 401k plan, and how much they can contribute. The amount you decide to contribute to your 401k is up to you. However, the IRS regulates the contribution limits every year.
The 2021 maximum 401k contribution:
- The 401k contribution limit is $19,500. But if you are age 50 or older, the catch-up contribution limit is an additional $6,500. So, you can save a total of $26,000.
Whenever possible, increase your retirement contributions up to the maximum allowed in your retirement plan. If you are a few years away from retirement, being short on retirement savings can be problematic.
The benefits of a 401k plan.
There are many tax advantages of saving money to a 401k plan.
First, the contributions you make to your 401k are tax-deductible. That means you do not pay taxes on the money you put into your account.
Your 401k contributions will be deducted from your gross income which will reduce your taxable income for that year. For example, if you made $75,000 and contributed $15,000 to your 401k, you would be only paying taxes on $60,000.
Next, your employer may match your contributions. The employer match means that your employer agrees to match a portion of your money going into the 401k account. Usually, the employer match is between 3 to 6 percent.
For example, your employer offers to match 50 percent on up to the first 6 percent you choose to contribute. So, if you make $75,000 a year and choose to contribute 6 percent of your annual salary ($75,000 x 0.06 = $4,5000), your employer will contribute an additional 50 percent of that amount. That free $2,250 ($4,500 : 2) will steadily grow over time.
If you do not put money into a 401k, there is no match. If your employer offers to match your contributions, I suggest at least save as much as the match. That is free money. In the end, you will be earning extra money for doing absolutely nothing.
Lastly, the money inside your 401k account grows tax deferred. If you open an investment account, you will have to pay taxes on your capital gains and dividends every year. But in a 401k plan, your money grows tax-free as long as it stays in the plan. And thanks to the power of compounding, your retirement savings will be growing faster over the years.
Related Post: Why Do You Need to Max Out Your 401(k)?
How to invest your 401k money?
Most 401k plans offer a limited number of investment choices. Your 401k is tied to your employment. When you sign up for a 401k plan, you have to choose from the investments offered by your employer’s plan.
Most 401k plans typically allow you to choose from a small number of pre-selected mutual funds that vary from conservative to aggressive. Some mutual funds are index funds, which track major market indexes. And other funds are target-date funds, which select a mix of investments appropriate for your age, but the fees can be very high.
Investing in index funds or target-date funds present less risk for you as an investor, than investing in individual stocks. But you need to understand which funds are best suited for your retirement goals, your age, and your risk tolerance.
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What to do with 401k when you change jobs?
When you change jobs, you have a couple of options:
Leave 401k with your old employer
Your first option is to do nothing and leave it with your old employer. If you like the investment options and costs offered by the plan administrator, your money will continue to grow in that 401k account.
But the biggest drawback to this option is that you can no longer contribute. To keep investing, you will have to open a 401k with your new employer. That means you will be juggling multiple statements and accounts every month.
Rollover old 401k to new 401k
Your second option will be to carry out a 401k rollover. A 401k rollover means you transfer your funds from the old 401k to your new employer’s 401k plan.
The rollover makes sense if you do not want to leave money with your former employer’s 401k, or simply want all your money in one account. That way, you will have more control over your contributions, and both of your accounts will be consolidated. Your new 401k plan administrator should help with transferring the funds.
Rollover 401k to IRA
Another popular option is to roll over the old 401k into an individual retirement account (IRA). I personally prefer this option because 401k plans usually do not offer the best investment options, and the administrative and management fees can be high.
A 401k plan can only be offered through an employer, but an IRA account can be open by anyone. You have a choice to select a brokerage firm, open an account and then ask them to roll over your 401k funds into a new IRA account.
One of the best benefits is that you do not need your employer’s approval when deciding how and where to invest your money. And typically, IRAs have lower fees than 401k plans so, you can save big on it over the years. Most of my IRA money invested into the low-cost index funds from Vanguard and Fidelity.
Cash out 401k
Finally, you still have an option to cash out your 401k money. It sounds like an easy option to cash out your old 401k and start over with a new employer. But if you try to cash out before a certain age, you will face an early withdrawal penalty. While there are exceptions like death, disability, or medical issues, you might lose a lot of money if you choose to take out your 401k funds early.
401k withdrawal rules
I believe it is wise to keep money in the 401k or IRA rollover plans as long as possible and delay taking money from these accounts that will add to your taxable income. But if you decide to cash out your 401k funds before a certain age, you need to be aware of rules on distribution.
Penalty for an early withdrawal:
If you withdraw 401k money before age 59 ½ and do not meet an exception that allows you to withdraw early, you will be paying both a 10 percent tax penalty as well as regular income tax on the funds you got withdrawn. That makes early withdrawals very expensive.
Impact of an early withdrawal:
For example, if you decide to take out $5,000 as an early withdrawal, you will have to pay the following, including penalties and taxes:
- Early withdrawal penalty (10 percent) = $500
- Federal and state tax withholding (20 percent tax rate) = $1,000
- The balance you receive: $5,000 – ($500+$1,000) = $3,500
You have to be 59 ½ years old to withdraw 401k (or IRA rollover) money without any penalties. However, certain conditions allow you to withdraw 401k money without any penalties at age 55. Sometimes it is called the Rule of 55.
The IRS makes an exception for middle-aged people. It spares you the 10 percent tax penalty if you have been laid off, fired, or leave a job between the ages of 55 and 59 ½. But you still have to pay a regular federal and state income tax on your withdrawals.
From IRS – the Rule of 55 explained
401k plan Required Minimum Distributions
The IRS calls them Required Minimum Distributions (RMDs). You cannot keep money in your 401k portfolio forever. When you turn 72 (it used to be 70 ½), the IRS requires you to start taking money out of your 401k.
Your 401k plan administrator will be sending you yearly payments from your account. The RMD payments will be different for each 401k owner. Each year you are required to withdraw an amount based on your life expectancy and how much money was accumulated in your account. And if you fail to make a withdrawal you will have to pay a tax penalty and still make a withdrawal. Additionally, you will pay a regular income tax on your withdrawals.
If you have more than one 401k, you will need to take a separate RMD from each account. That is why it will be easier to combine all 401k accounts into one when you retire or ready to withdraw your retirement savings.
It is good to remember that many brokerage firms offer a service of calculating your RMD and sent the paycheck to you automatically.
Related Post: Smart Ways to Take Money Out of Retirement Accounts
The Bottom Line
The 401k plan has grown to become the most popular retirement plan in America sponsored by employers. Many people depend on the money they have invested in 401k plans to provide for them in their retirement years. A 401k plan offers a great opportunity to save for your golden years. Without your 401k savings, you will be only relying on a Social Security paycheck which can easily turn into a meager existence.
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