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401k benefits

If your company offers a 401(k) plan, you’re in luck. These savings vehicles help you save for retirement as you enjoy some tax breaks. This article will explain how they work and all you need to know to start investing in your Golden Years. We can also help you find a financial advisor to help you invest on a 401(k) plan the right way.

What Is a 401(k) Plan?

A 401(k) plan is an employer-sponsored retirement savings vehicle. Companies typically enroll their employees in one, so you might already have an account. 401(k)s are funded directly from your paycheck on a pre-tax basis. This means that contributing toward one reduces your taxable income. This move could help you sink to a lower tax bracket.

But that’s not all. 401(k) plans offer additional tax breaks.

401(k) Tax Benefits

When you invest in a 401(k) plan, your money grows tax free as long as it stays in the plan. This means you won’t be taxed on your investment earnings as you would have if your money was in a different type of account.

In fact, you won’t get taxed until you withdraw your money. However, the IRS sets strict rules around when you can do this. You’re allowed to make withdrawals once you reach age 59.5. Otherwise, the IRS may charge a 10% 401 (k) arly-withdrawal penalty.

How Does a 401(k) Work?

Companies typically enroll their employees in a 401(k) if they offer one. Firms usually offer an investment menu with different mutual funds and low-cost exchange-traded funds (ETFs) that you can choose from. Some companies auto enroll their employees into target-date funds (TDFs).

These funds automatically rebalance their asset allocation as you age and get closer to retirement. The objective here is that these funds invest in less equities as you age in order to align with your risk tolerance. Of course, you can build your own portfolio using the funds in your company’s investment menu.

In any case, you’re free to increase or decrease contributions toward your 401(k) plan. Your company may even match your contributions up to a certain limit.

401(k) Plan Rules

401k benefits

The 401(k) plan is named after the section of the tax code that establishes it. So, you can expect it to have several rules. One thing you should be aware of, however, is that 401(k) plans have contribution limits. The IRS sets these maximums each year. For the 2019 tax year, that limit stands at $19,000. Those who are aged 50 or older can contribute up to $6,000 more. This is considerably larger than the limits for individual retirement accounts (IRAs), which stand at $6,000 for 2019

As mentioned above, you can face some serious consequences if you withdraw money from your 401(k) plan before you reach age 59.5. Typically, you won’t be able to take a withdrawal until you reach this milestone. However, you may be able to take a hardship withdrawal. In most cases, however, you will face a 10% penalty on your withdrawal in addition to regular income tax. Your state may levy additional taxes as well.

In addition, you have to begin making required minimum distributions (RMDs) when you reach the age of 70.5.

Consider a Roth 401(k)

Some companies also offer Roth 401(k) plans. These aren’t funded on a pre-tax basis, so contributing to one won’t reduce your taxable income. However, you can make tax-free withdrawals once you reach the age of 59.5. If you’ve had the account for at least five years.

The Takeaway 

Investing in a 401(k) can help you begin establishing a comfortable retirement today. Plus, your money grows tax free until you withdraw it. However, you must be at least 59.5-years-old in order to do this without penalty. Most companies offer diverse investment menus that include TDFs. These automatically rebalance their investment to fall in line with your risk tolerance.

Tips on Investing in a 401(k) Plan

  • When you open a 401(k), you have many investment options to choose from. But not each one is right for everyone. Luckily, you can find a financial advisor to help you choose the ones that most closely reflect your risk appetite and financial goals. We can help you find a financial advisor with our matching tool. After you answer a few simple questions, you’d be connected with up to three advisors in your area.

Photo credit: ©iStock.com/R.M. Nunes, ©iStock.com/DNY59, ©iStock.com/swissmediavision

Javier Simon, CEPF® Javier Simon is a banking, investing and retirement expert for SmartAsset. The personal finance writer's work has been featured in Investopedia, PLANADVISER and iGrad. Javier is a member of the Society for Advancing Business Editing and Writing. He has a degree in journalism from SUNY Plattsburgh. Javier is passionate about helping others beyond their personal finances. He has volunteered and raised funds for charities including Fight Cancer Together, Children's Miracle Network Hospitals and the National Center for Missing and Exploited Children.
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