A 401(k) is like a savings plan for when you retire, and it’s offered by your employer. You set aside a portion of your salary for this account, and you have the option to invest it in stocks. Plus, there are some tax benefits that come with being a part of it. In simple terms, a 401(k) is a way to save for your retirement through your job.
What is a 401(k)?
The exciting part about a 401(k) is how it can benefit you. It’s a great tool for securing your financial future, especially when you begin using it early in your career. In simpler terms, if you’re a fan of money and want more of it down the road, a 401(k) can help you achieve that.
Now, let’s dive into how a 401(k) functions, when you can take money out of it, and what occurs with your 401(k) if you switch jobs.
How does a 401(k) work?
To join your company’s 401(k) plan, you’ll usually need to work there for a certain period, but many employers allow you to start within a month or two of being hired.
The amount you put into your 401(k) from each paycheck depends on your contribution rate. This rate is a percentage of your salary that you choose to contribute. For instance, if you earn $45,000 per year (or $3,750 per month), a 10% contribution rate means you’ll put $375 from your monthly paycheck into your retirement plan.
Don’t worry if that sounds like a big chunk of your income. Thanks to the 401(k)’s tax advantages, the $375 you contribute won’t cost you the full $375. Your paycheck contributions are tax-deductible, which means they’re taken out of your pay before income taxes are calculated. This reduces your taxable income and, as a result, lowers your income taxes.
Some 401(k) plans offer something called a “matching contribution,” which is essentially free money from your employer. Matching contributions follow a formula set by your employer. Typically, they might contribute $0.50 for every $1 you put in, up to 6% of your salary.
Those are just a couple of the key points about 401(k) plans. Another perk is that your investment earnings in a 401(k) are tax-deferred. Normally, you’d owe taxes each year on the interest, dividends, and profits from investments you sell. But with a 401(k), you can earn as much as you want, and you won’t pay taxes until you take money out of the account.
How much can I contribute to a 401(k)?
You can’t just dump your entire paycheck into your 401(k), unfortunately. The IRS has some rules in place to keep things in check. They set limits on how much you can put in from your paycheck and how much both you and your employer can contribute in total. These limits can change from year to year, but here’s the scoop for 2022 and 2023:
- In 2023, you can stash away up to $22,500 (or $20,500 in 2022) from your salary into your 401(k). Unless you’re a highly compensated employee, there might be some exceptions.
- If you’re 50 or older, you’re in luck. You can kick in an extra $7,500 per year in 2023 (up from $6,500 in 2022). These bonus contributions are called “catch-up contributions.”
- Your total contributions can’t exceed your salary or $66,000 in 2023 ($61,000 in 2022), whichever is less. These limits don’t count the catch-up contributions. This total includes the money you set aside from your paycheck, any matching contributions, and any other contributions your employer makes.
- If you accidentally put in too much, don’t fret. Just get in touch with your plan administrator.
- You can save in both a 401(k) and an IRA or Roth IRA, but there are some rules to follow.
What is a Roth 401(k)?
Certain 401(k) plans offer something called Roth contributions. Now, a Roth 401(k) contribution plays by different tax rules compared to your regular 401(k) deposit. Here’s the scoop:
With a traditional 401(k), you get a tax break upfront because your contribution is tax-deductible. But when you take out the money in retirement, you’ll have to pay taxes on it.
Now, the Roth contribution is the flip side. You don’t get a tax deduction when you put your money in, but the big win is that when you withdraw it during retirement, you won’t owe any taxes. It’s like a tax-free savings account for your golden years.
Withdrawing from your 401(k)
Your 401(k) is like a savings plan for your retirement, so there are some rules about when you can take money out. Here’s the lowdown:
Early Withdrawals: If you try to take money out before you’re 59 and a half years old, you’ll likely face a 10% penalty. There are a few exceptions, but in general, it’s best to wait.
Retirement Withdrawals: Once you reach the magic age of 59 and a half, you can start taking money out without the penalty. If you’re not working for the company anymore, you might even start at 55. But remember, the money you withdraw is considered regular income, so you’ll pay taxes on it.
Required Minimum Distributions (RMDs): If you don’t need the money right away, you can keep it in your account until you’re 73 (used to be 72). After that, you’ll have to take out a certain amount each year, known as “required minimum distributions” (RMDs). How much you take out depends on your age and how much you have in your 401(k).
401(k) Loan: Some plans let you borrow from your 401(k) without a penalty. You do have to pay interest on the loan, but the cool thing is, you’re paying interest to yourself. However, if you change jobs, you usually have to pay back the loan by the time your next tax return is due.
So, while your 401(k) is a great way to save for retirement, make sure to follow these rules to avoid any penalties or surprises.
401(k) rollovers
Your job might not stick around forever, but your 401(k) savings can. When you switch jobs, you can take your retirement money along with you. Sometimes, if your account has a certain amount of money in it, your old employer might even ask you to move your funds out of their plan.
No matter what, you’ll want to do what’s called a “401(k) rollover” to avoid any unwanted taxes or penalties. There are two main types of rollovers:
Direct Rollover: You simply ask the person in charge of your 401(k) to send your money directly to another retirement account, like an individual retirement account (IRA) or your new employer’s 401(k). The good news is, no taxes are taken out of your funds.
60-Day Rollover: If your old employer sends your 401(k) money directly to you, you’ve got 60 days to put that money into a different retirement account, like an IRA or a different 401(k). Here’s where it gets a bit tricky: your old plan will usually hold back 20% for taxes from the money they send you. However, the amount you need to deposit in your new account is the full balance, including the taxes they held back. If you put in less than the full amount, you’ll have to report the difference as taxable income on your next tax return. Plus, there might be a 10% penalty if it’s an early withdrawal.
Let’s break it down with an example: Suppose your 401(k) balance is $5,000 when you leave your job. Your employer sends you a check for $4,000, keeping $1,000 for taxes. You’ve got 60 days to put the entire $5,000 into another retirement account. If you only put in the $4,000 you received, you’ll need to report that extra $1,000 as taxable income. And if it’s an early withdrawal, you could face a 10% penalty too.
So, when you switch jobs, remember to rollover your 401(k) properly to keep your retirement savings intact and avoid any unexpected tax issues.
401(k) for financial independence in retirement
Your 401(k) is like a secret wealth-building helper for your retirement. After you tell it what you want, it quietly goes to work, saving and investing money for you without you having to do much. And, there are tax benefits and maybe even extra contributions from your employer that make your savings grow even faster.
Here’s the bottom line: The sooner you begin putting money into your 401(k), the more you’ll gain from its perks, and the more money you can have when you retire. So, start early and watch your retirement wealth grow.
