WHAT IS A 401(K) AND HOW DOES IT WORK?

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

One of the most common ways people save for retirement is by contributing to a 401(k), a retirement savings account offered by many employers. So what is a 401(k) and how does it work? We’ll look at three main concepts: contributions, investments, and account management. But first let’s start with the absolute basics: the name. It’s called a 401(k) because of the section of the IRS code that sets out the rules for this type of account, section 401 subsection. Basically, the government allows companies to offer retirement savings accounts with certain tax advantages in an effort to encourage people to save for retirement. 

What are the advantages of 401(k) retirement plans?

Tax advantages are one of the main benefits of contributing to a 401(k). When you sign up for a 401(k), you’ll set an amount or percentage to be automatically taken out of each paycheck to fund the account. With a traditional 401(k), the amount you contribute is deducted from your taxable income. Let’s say you earn $100,000 per year and contribute $10,000 to your 401(k). That means your total taxable income for the year would be $90,000, reducing the amount you have to pay taxes on that year. In addition, the money you contribute to a 401(k) can grow tax-deferred,  meaning you don’t pay taxes on it until you withdraw it in retirement. 

In the meantime, the money in the account can compound without being taxed. Some employers also offer a Roth 401(k), which allows you to contribute after-tax dollars. Instead of decreasing your tax burden now, this allows you to take the money out tax free during retirement. Only you can determine which 401(k) is right for you. 

What are the factors to determine which 401 (k) plan is best for you?

It depends on several factors some of which are mentioned below:

  • How much you expect to earn later in life 
  • Whether you want tax benefits now or later. 

Some people choose to contribute to both. Talk to a tax professional for more information. 401(k) tax benefits have some limits. The money you put in a 401(k) is basically untouchable until you turn 59 and a half. If you withdraw money before then, you’ll face an early withdrawal penalty and income tax unless you qualify for one of the few exceptions, like paying for substantial medical expenses or disability. Overall, it’s best to avoid jeopardizing your retirement savings with early withdrawals. 

What are the IRS limits you can contribute to your 401 (k)?

The IRS limits how much you can contribute to a 401(k) each year. These limits have changed over the years and can depend on your age, so it’s best to check with the IRS or a tax professional. Another major benefit of participating in a 401(k) is that some companies offer a match. That’s extra money the company contributes to your account just for participating, and it doesn’t count toward your individual limit. So, say your employer matches 50% of all your contributions up to 6% of your annual salary. This means if you make $50,000 and you contribute that’s $3,000 your employer would contribute $1,500 on top of that. If your employer is offering a good match be sure to contribute enough to get the maximum amount. Don’t leave free money on the table. Keep in mind, some companies have what’s called a vesting period. That’s the period of time you have to work there before the money the company   contributes becomes fully yours. Check with your employer to learn more about your company’s policy. 

Now that you understand contributions, let’s talk about choosing investments. 401(k)s typically offer a limited number of investments, like mutual funds or exchange-traded funds. If you find the number of investment choices too limited, see if your employer offers a self-directed 401(k). These plans may provide additional investment choices. Either way, you’ll have to weigh the risks and fees associated with each investment. It’s generally best to not take the money out until you reach retirement age, so focusing on long-term investing rather than quick profits might be a prudent choice. 

What can be drawbacks for your 401(k)s?

Though these are retirement plans for the person, every plan has its pros and cons. Here are some of the cons which you can check while choosing a 401 (k):

The Fees for 401 (k) plans

Some 401(k) providers charge additional administrative fees on top of the cost of individual investments. These fees are not always obvious, so check with your plan administrator or use an online 401(k) fee analyzer. If you’re unhappy with the fees you’re paying, you can consider other retirement accounts like Individual Retirement Accounts, or IRAs. Even if your 401(k) offers limited investment choices or charges high fees, it may still be worth contributing enough to get the maximum match from your employer. The match may outweigh these drawbacks. Over time, you’ll likely work for several companies, which could mean you have many 401(k)s. So what do you do with those old accounts? You can always combine them into your current 401(k) or an IRA through a process called a rollover. This allows you to move funds directly from one retirement account to another without incurring tax penalties.

Conclusion

Keeping your retirement savings in fewer accounts may make them simpler to manage. The 401(k) is just one kind of retirement account, but the tax benefits and potential employer match make it a powerful way to invest for the future. Contributing to a 401(k) is one of the simplest ways to pay yourself first.

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