A 401(k) is a common tax-advantaged retirement savings plan that’s available to employees through their employer. These accounts come in traditional and Roth variations, with each having their own tax benefits according to IRS tax laws. Because 401(k)s are integrated through an employer, you can easily contribute to your 401(k) account directly through your paycheck. While valuable, a 401(k) should only be a part of your overall retirement savings plan. A financial advisor in your area can help you expand your plans based on your personal needs.
How Does a 401(k) Work?
A 401(k) is an employer-sponsored plan in which you divert portions of each paycheck into a retirement investing account. This is a defined contribution plan because account holders regularly contribute a set amount to their account. This is in contrast to defined benefit plans, like a pension, where it’s the payouts in retirement that are predetermined.
How much you subtract from your paycheck and contribute to your 401(k) is entirely up to you. Just know that for 2020, the IRS generally caps annual contributions at $19,500.
To help you grow you retirement savings, many employers offer 401(k) matching contributions. In other words, your employer will also contribute to your account up to a certain dollar amount or percentage of your annual salary. This basically amounts to free money, so you should make every effort to at least contribute up to that limit if your employer offers matching.
401(k) plans are only accessible through an employer. So if your company doesn’t sponsor a 401(k) plan, you won’t be able to get your hands on an account.
Traditional 401(k)s vs. Roth 401(k)s
There are very few differences between the specifics of most 401(k) plans. However, the tax benefits associated with your personal account will vary depending on the type of account you choose to open. In fact, just like an individual retirement account (IRA), 401(k)s come in two specific variations: traditional and Roth.
As you might expect from their title, traditional 401(k)s are the most common type of 401(k). The major benefit of them is that your contributions are tax-deferred. This means that the money you reroute from your paycheck goes directly to your 401(k) without being subject to income taxes. Once you retire and begin taking withdrawals, however, you’ll owe taxes on that money.
By opting for the traditional 401(k), you’re effectively deducting any contributions you make from your taxable income. As a result, you’ll pay less in taxes than you would if that money was considered taxable income. Then, since you’ll probably end up in a lower tax bracket in retirement, the tax rate you pay on your withdrawals could be lower than they would have been during your working years.
Although most of the logistics of a Roth 401(k) are identical to its traditional counterpart, the way its funds are taxed is drastically different. With this type of account, your money will be taxed before it’s contributed to your balance, meaning these retirement assets will be classified as “after-tax” in the eyes of the IRS. So while this will increase your taxable income in the short term, you won’t owe any income taxes when you withdraw in retirement.
What Are the Contribution Limits for a 401(k)?
Regardless of the type of 401(k) you open, the IRS levies specific annual contribution limits for all 401(k) account holders. The general employee contribution limit is $19,500 for 2020, which is a $500 increase over the $19,000 2019 limit.
If you own a 401(k) and you’re 50 or older, the IRS allows you to make “catch-up contributions.” For eligible account holders, the catch-up contribution limit is $6,500. Again, this cap saw a $500 jump from the 2019 limit of $6,000.
The IRS also institutes a cap on the joint contributions of you and your employer through any applicable matching programs. For 2020, the joint contribution limit is the lesser of $57,000 or 100% of an employee’s compensation. In 2019, this limit was $1,000 lower at $56,000.
Investing Through Your 401(k)
The administrator of your 401(k) plan decides on a handful of investment options that you will choose from. These are usually some combination of mutual funds, including target-date funds. It’s very rare to have a 401(k) that allows you to invest in individual stocks or bonds.
When you’re deciding how to invest, you’ll want to factor in your risk tolerance, age and how much you need for retirement. To simplify things, many people choose to invest in the aforementioned target-date funds. These automatically rebalance your portfolio to become more risk-averse as you approach the year of your retirement.
Once you decide between the investment choices, you’ll need to pick what percentage of your paycheck you want to allocate to your 401(k) account. There’s no magic percentage, as everyone’s financial situation is different. Ideally, you’ll contribute as much as you can while still keeping enough to manage your day-to-day and monthly expenses. At the very least, though, you should aim to contribute at least as much as your employer will match.
How to Open and Manage a 401(k)
If your company offers a 401(k), be sure to actually enroll in it or you won’t have an account. The exact procedure for opening a 401(k) varies from company to company. If you work in an office, you’ll likely have an HR representative who can provide you with instructions or other resources to help you set up your account. Otherwise, you can always ask your supervisor or colleagues if you don’t know how to get the ball rolling.
It might be worth consulting with a financial advisor if you have questions about how a 401(k) fits into your overall retirement plans. SmartAsset’s free matching tool can pair you with advisors in your area.
There are four main options you have to manage your 401(k) when you leave your company. You can either withdraw the money directly from your account, roll it over into an IRA, move it to your new company or keep it with your old company.
Immediately withdrawing your money from your account is the option you should avoid at all costs. This is because those funds then factor into your taxable income, heavily increasing your tax burden for the year. In addition, if you’re younger than 59.5 years old, the IRS will slap you with a 10% income tax penalty. Your best bets are to either leave your 401(k) with your old employer, take it with you to your new job or roll it over into a shiny, new IRA.
If you have yet to set up a 401(k), but you can afford to divert some money from your take-home pay, then open your account as soon as possible. 401(k)s offer a simple and easy way to save for your retirement, while lowering your taxable income in the present. If your employer offers any sort of match, it’s even more in your best interest to start contributing. If you don’t, you’re basically turning down free money toward your retirement. However you do it, the most important things are to figure out what you need for retirement and to start saving towards those goals.
Tips for a Financially Successful Retirement
- No matter how close or far you are from retirement, juggling all of your accounts and investments on your own can get difficult. A financial advisor can take a comprehensive look at your finances and help manage your money on your behalf. Luckily, SmartAsset’s free matching tool makes it easy to find suitable advisors in your area. Get started now.
- During the retirement planning process, it’s important to think about the retirement tax laws of the state you want to retire in. By minimizing your retirement tax burden, you can maximize the value of your savings in retirement.
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