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A Beginner's Guide to Understanding 401ks

The word 401k is synonymous with retirement, but how many of us actually know all the rules around 401ks? We've made this FAQ to walk you through all the basics, but rather than forcing you to actually read through all this... yawn... financial talk, we've made a table of contents for you.

    1. What is a 401k?
    2. How does a 401k work?
    3. What are the benefits of a 401k?
    4. What is the maximum 401k contribution for 2018?
    5. What happens to my 401k if I change jobs?
    6. What is an IRA?
    7. How is an IRA different from 401k?
    8. When can you withdraw from your 401K without a penalty?
    9. How much should I be putting into my 401k?
    10. What are the penalties if I cash out my 401k early?
    11. What are other types of retirement accounts?

 

What is a 401k?

A 401k is an employer-sponsored retirement account. It allows an employee to dedicate a percentage of their pre-tax salary to a retirement account.  These funds are invested in a range of vehicles like stocks, bonds, mutual funds, and cash.

 

How does a 401k work?

A 401k plan is a benefit commonly offered by employers to ensure employees have dedicated retirement funds. A set percentage the employee chooses is automatically taken out of each paycheck and invested in a 401k account. They are made up of investments (usually stocks, bonds, mutual funds) that the employee can pick themselves.

Depending on the details of the plan, the money invested may be tax-free and matching contributions may be made by the employer. If either of those benefits are included in your 401k plan, financial experts recommend contributing the maximum amount each year, or as close to it as you can manage.

 

What are the benefits of a 401k

401 tax benefits are hard to dispute, as they can offer workers a lot of financial security, including:

  • Employer match

  • Tax breaks

  • Shelter from creditors

Let's dig in a littler deeper.

 

401k employer match

Do you like free money? Good, now that we've got that out of the way, a company-matched 401k is basically that. Many employers offer to match employee contributions, either dollar for dollar or 50 cents to the dollar, up to a set limit. So, for example, say you make $100,000 a year (#baller) and your employer offers a 401k matching of 50% up to  the first 6% you elect to contribute. If you contribute 6% of your annual earnings ($6,000), your employer would contribute an additional 50% of that amount. So, 3,000 free dollars.

It's up to your employer to decide what percentage they will match, but many companies do offer a dollar-for-dollar match.

 

401k tax breaks

The tax benefits of 401ks are like the triple-crown of finances. First, contributions are pre-tax. You don’t pay taxes on the money until you withdraw it when you retire. (At the earliest, this is age 59.5.)

Second, your 401k contributions are not counted as income, which could put you in a lower tax bracket. The result: your tax bill will be smaller for your having squirreled away money for your later years.

Third, your savings grow tax deferred. In a regular investment account, your net gains and dividends would be taxed. But in a 401k plan, your money grows tax free as long as it stays in the plan. This allows your earnings to compound -- which is just a fancy way of sayings, your earnings will earn earnings. 

 

401k shelter from creditors

If your finances take a turn for the worst, you won't have to worry about creditors coming for your 401k. Your qualified retirement plan is protected by the Employee Retirement Income Security Act of 1974 (ERISA) from claims by judgment creditors.

 

What is the maximum 401k contribution for 2020?

That depends on your employer's plan. But, good news ya'll. The maximum the IRS allows for 2020 is up from the previous year. Currently the cap sits at $19,500 but your employer may cap the amount below that. For people over 50 the maximum increases to help them "catch up" before their retirement. They can contribute an additional $6,500 a year.

 

What happens to my 401k if I change jobs?

You have a couple options, but the one most would recommend is a 401k rollover. A 401k rollover is when you transfer your funds from your employer to an individual retirement account (IRA) or to a 401k plan with your new employer. A much less popular option is to cash out your 401k, but this comes with massive penalties; income tax and an additional 10% withholding fee.

 

What is an IRA?

 While there are lots of benefits to 401ks, they're not the only retirement plan in the game. An IRA is an individual retirement account. Where a 401k can only be offered through an employer, an IRA account can be opened up by an individual whether they're associated with an employer or not. That means they're the best option for independent contractors without an employer or anyone who wants to do some extra retirement planning on top of their 401k.

 

What is a Roth IRA?

A Roth IRA is a type of individual retirement account similar to traditional IRAs in many ways, but with some significant differences. One of the main differences is how the tax breaks are different: with a traditional IRA, the money you put in isn't taxed; with a Roth IRA the money you take out (once you've reached retirement) isn't taxed. Roth IRA's also have no requirements on when the money must be taken t, so they can be a good tool to pass along wealth to your beneficiaries if you find you don't need the money in retirement.

 

What are the rules for a Roth IRA?

Roth IRAs are only available to people making less than $129,000 a year as an individual, or $191,000 for married couples. They have contribution limits of $5,500 a year, or $6,500 for those over 50. Unlike 401ks and traditional IRAs though, there's no penalty for withdrawing part of your contribution early.

 

What are the traditional IRA contribution limits?

A traditional IRA has the same contribution limits as a Roth IRA: $5,500 for most people, $6,500 for anyone over 50.

 

How is an IRA different from 401k?

 401K accounts are associated with your employment, as contributions are taken out of your wages before taxes. A traditional IRA is similar to a 401k in that contributions aren't taxed (they are deductible), but the key difference is that they are independent of your employer. A Roth IRA is also independent, but contributions are made after taxes. Withdrawals from your Roth IRA are tax-free, which makes them a smart choice if you think taxes will be higher in the future.

 

When can you withdraw from your 401K without a penalty?

Wondering when can you withdraw from 401k? 59 and 1/2 is the current age when you can take money out of your 401k without incurring a penalty. However, the money you take out is still taxed as income. At the age of 70, you will be forced by the IRS to start taking distributions from your retirement accounts.

 

How much should I be putting into my 401k?

Aim to save between 10% and 15% of your income toward retirement. Another piece of general advice is to put all of those funds into your 401k up until your employer's matching contribution amount. Once that has been reached, maxed out your Roth IRA contribution. If there are fund left over (lucky you!) then consider putting those funds into your 401k.

Another way to determine how much you will need to save is to look at what income amount you will need in retirement. Fortunately, there are a lot calculators out there that will help you figure out your magic number. Here are two of our favorites.

  • Nerdwallet provides a great basic calculator that lets you play with different contribution and matching amounts.

  • CalcXL makes a recommendation on how much you should be saving based on projected inflation. Tip: You should aim for a retirement income of roughly 80% of your current salary. 

What are the penalties if I cash out my 401k early?

If you withdraw funds from your 401k before the age of 55 and 1/2, then you will pay a 10% early withdrawal penalty and taxes on all the funds. This adds up. Assume you have $250,000 in your 401k and you want to take it out early. After penalties, you will have around $180,000. A loss of $70,000.

Are there other kinds of retirement accounts?

401k and IRAs are the main two. There are a couple of other types available to small business owners or the self-employed: SEP IRAs and Simple IRAs. You can learn more about those here.

Tags: Saving, Personal Finance