What Is a 401(k)? Everything You Need to Know
When it comes to retirement planning, a 401(k) is one of the most popular and effective tools for Americans.
But what is a 401(k)? This guide will cover everything you need to know about 401(k) plans including the benefits, how they work and why they are key to a secure financial future.
What is a 401(k)?
A 401(k) is an employer sponsored retirement plan. You can save and invest a portion of your paycheck before taxes are taken out. The money in a 401(k) grows tax deferred, meaning you don’t pay taxes on the money until you withdraw it, usually in retirement. This tax advantage is one of the main benefits of a 401(k) plan.
RELATED TOPICS:
Types of 401(k) Plans
There are two types of 401(k) plans: Traditional and Roth. Each has its own features and tax implications.
Traditional 401(k)
With a Traditional 401(k), contributions are made with pre-tax dollars. This means the amount you contribute reduces your taxable income for the year. But you will have to pay taxes on the money when you withdraw it in retirement.
Roth 401(k)
With a Roth 401(k), contributions are made with after-tax dollars. You don’t get a tax break upfront but the big advantage is withdrawals in retirement are tax-free if you meet certain conditions. This can be especially good if you expect to be in a higher tax bracket in retirement.
How Does a 401(k) Work?
A 401(k) plan works by allowing you to contribute a portion of your paycheck into a retirement account. Employers may also offer a matching contribution which is essentially free money that adds to your retirement savings. For example an employer might match 50% of contributions up to 6% of your salary.
Contribution Limits
The Internal Revenue Service sets annual contribution limits for 401(k) plans. For 2024 the limit is $23,000 for individuals under 50. Those 50 and older can make additional “catch-up” contributions of $7,500 bringing the total to $30,500. Be sure to stay informed on these limits as they change.
Investment Choices
401(k) plans offer a variety of investment options including stocks, bonds and mutual funds. The plan administrator will provide a list of funds and it’s up to you to decide how to allocate your contributions. Be sure to consider your risk tolerance and time horizon.
401(k) Benefits
Tax Benefits
The biggest benefit of a 401(k) is the tax benefits. Contributions to a Traditional 401(k) lower your taxable income, so you pay less in taxes for the year. Roth 401(k) contributions aren’t tax deductible but offer tax free withdrawals in retirement.
Employer Match
Many employers offer a match to your 401(k) which is free money for your retirement. This can add up fast. For example if your employer offers a 100% match up to 5% of your salary and you make $60,000 a year, contributing 5% means you’ll get an extra $3,000 from your employer each year.
Compounding
The money in your 401(k) grows tax deferred, so you won’t pay taxes on the investment gains until you withdraw the money. This allows your investments to grow faster than they would in a taxable account. Compound interest can add up big time to your retirement savings over the years.
Pros and Cons
Early Withdrawal Penalties
While a 401(k) has many benefits, there are some drawbacks to be aware of. One is the penalty for early withdrawal. If you withdraw from your 401(k) before 59½, you may be hit with a 10% early withdrawal penalty plus income taxes on the amount withdrawn.
Required Minimum Distributions (RMDs)
Once you turn 73, you must start taking Required Minimum Distributions (RMDs) from your Traditional 401(k). These withdrawals are taxable. Not taking the required amount can result in penalties.
Limited Investment Choices
While 401(k) plans offer many investment options, they are limited compared to what you could have in an individual retirement account (IRA) or a brokerage account. Be sure to review the investment options and fees of your plan.
Bottom Line
A 401(k) is a great way to build a safe retirement. Knowing the benefits (tax benefits and employer match) and the drawbacks (early withdrawal penalties and limited investment options) will help you make smart decisions. Whether you choose a Traditional or Roth 401(k) starting early and contributing consistently will get you on the path to a comfortable and financially secure retirement.
Maximize your 401(k) contributions and make smart investment choices. Because it’s your ticket to a safe and prosperous retirement.
Get started today!
YOU MAY ALSO LIKE: