A 401(k) is a type of qualified retirement savings plan where contributions are made by an employee into pre-selected investment funds chosen by their company. Once the employee contributes into the account, the employee owns the assets within the account. Unlike a regular pension, the employee does not receive a monthly payment from the 401(k) fund. Instead, they receive distributions only if they reach 59 and a half years old, retire, or pass away. One good thing about a 401(k) is that you can make contributions throughout your career without jeopardizing eligibility for Social Security benefits. However, you must begin contributing no later than six months after you start working full-time.

How A 401(k) Works

Because a 401(k) is an employee-sponsored investment plan, you won’t be able to open an account apart from your employer. The way it works is you regularly invest portions of your salary into a tax-deferred savings plan. This is in comparison to defined benefit pensions, where the payout is determined in later years.

You’re free to decide how much to deduct from your paychecks and contribute to your retirement accounts each year. This is something you need to plan too, or else you may be subject to an additional tax bill next April.

Take advantage of 401(k) matching if your company offers it. This means they’re contributing money into your retirement fund for you.

Types of 401(k) Plans

As you may expect from their name, traditional 401(k)’s are the most common type. They’re also known as “simplified” because they offer fewer investment options and lower contribution limits. They allow you to defer paying taxes on your retirement savings until you withdraw the funds. That’s why they’re so popular.

If you opt for the traditional 401(k) plan, you’ll be able to deduct any contribution you make to your account from your taxable income. Because you’ll likely end up in a lower income tax bracket when you retire, the tax rate you’ll be paying on your withdrawal may be lower than it would have been had you not made any deductions.

Although most of the logistics of using a Roth 401(k), including contributions, withdrawals, etc., are similar to their traditional counterparts, the fact that your retirement savings are taxed differently means they’re not considered “before- and after” by the IRS. Instead, they’re considered “after and before.” As a result, you don’t pay federal taxes on them until you take out some or all of your earnings during retirement.

Are there Contribution Limits for a 401(k)?

For employees who participate in their company’s retirement plan, regardless of the type of 401(k) they open, the IRS levies specific annual contribution limits. Employees may contribute up to 20% of their salary ($20,500 for 2022).

If you have an individual retirement account (IRA) or similar retirement plan and are at least 50 years old, the IRS lets you contribute up to $6,500 for 2019. This cap stays the same through 2021.

If you’re married, the maximum combined tax savings for both spouses is capped by law. In 2022, the joint tax savings cap is $2,500 less than it was in 2018.

How Investing Through Your 401(k) Works

Your employer decides which investments you’re allowed to pick from. Usually, these include mutual fund companies, but not always. You might be able to select individual stock or bond investments if your company offers them.

You’ll want to consider your risk tolerance, your current financial situation, and when you plan to retire before making any investment decisions. Many people opt to put their money into a fund that automatically adjusts its asset allocation to become more conservative as they get closer to retiring.

Once you’ve decided how much money you’re willing to invest into your retirement savings plan, you’ll need to figure out where to put that money. You may not be able to afford an entire contribution right off, so start small. For example, if you make $50,000 per year, you might only be able to save about 10% of your income each month. However, if you can swing 20%, then you’d be contributing $10,000 per year.

How to Open and Manage a 401(k)

If you’ve got the skills and knowledge, then you should start putting together a plan. A good place to begin would be with a financial advisor. They can give you advice about what kind of 401(k) plan would suit your needs best, and also assist you in creating one. Another person you can approach is your employer’s Human Resource department.

When leaving your job, there are four main options for managing your retirement savings: withdrawing the funds directly from your account, rolling them over into an IRA, moving them to your new employer, or keeping them with your current employer.

If you withdraw any money from your retirement accounts, it becomes part of your taxable income. Also, if you’re under 59.5 years old and you’ve got an IRA, you’ll get slapped with a 10 percent early withdrawal fee. Your best bet is to either move your 401(k) plan with your current company to your new one or roll it over into an IRA.

The Main Point

If you haven’t started setting up a 401(k) plan, then you should get one right away. A 401(k) works to invest pre-tax dollars into an IRA. You’ll receive tax breaks for doing so, and you’ll also receive matching funds if your company matches contributions. In addition, you’ll have access to investment options that may not otherwise be available to you. By investing early, you’ll reduce the amount of taxes you owe later in life. Plus, you won’t have to worry about finding extra cash every month to contribute to your retirement fund.

Final Financial Planning Tips for Retirement

  • No matter how close you are to retiring, juggling all of your accounts and investments yourself can be difficult. A financial advisor takes a comprehensive look at your finances and helps manage your money on your behalf.
  • It’s important to consider the state’s income taxes when thinking about retiring in that state. If you minimize your state’s tax burden by moving to another state, you can increase the financial benefit of your savings in that new state.