More than half of all working Americans believe that Social Security won't be there for them when they are ready to retire. People's uncertainty about the long-term sustainability of Social Security is one reason why it's more important than ever to plan and save for retirement. One common investment vehicle that most people have heard of is 401(k) plans. There are many reasons why 401(k)s are often the first retirement account people open and why almost all financial gurus suggest opening one. However, that doesn't mean that it's easy to understand what a 401(k) is or why it's important to have one.
What Is a 401(k)?
A 401(k) plan is a tax-advantaged account named for the part of the U.S. Internal Revenue Code under which these accounts fall. When they use a 401(k), people agree to have part of their paycheck deposited straight into a retirement account. Some employers match the employee's investment. The plans are chosen by administrators, but most plans allow investors to decide how to invest their money from a set number of options.
How Do You Start a 401(k)?
Most people's first day of work at a new job contains very little work but does involve a lot of paperwork. New employees have to get logins to company networks, set up direct deposit, pick a health insurance plan, choose a voicemail code, and decide how they would like to save for retirement. All contributions to a 401(k) plan are made with pre-tax dollars. This means that the amount contributed is removed from the paycheck before any other taxes are taken out and the employee never receives this money in their bank account.
The first thing an employee needs to know is if they are eligible for any employer match and, if so, how much the employer match is. Employees offered a match should contribute whatever they need to so that they receive the full match. If the employer doesn't offer a match or only matches contributions for employees who have worked for the business for a certain amount of time, then it's up to the employee to decide how much they can save. It's a good idea to work out a budget for this before the first day on the job. The human resources department or whoever is in charge of onboarding new employees will have all of the information needed to set up a 401(k) and the automatic contribution.
How Does a 401(k) Earn Money?
Retirement accounts, including 401(k)s, grow in a few different ways. One is with the contributions from the employee that are taken out of every paycheck. Employer contributions also can help grow an account if you're eligible for them. All of this money is then invested through the 401(k). Investments that grow or return a profit are vital for the growth of a retirement account. Very few people can afford to simply save enough to retire: Almost everyone depends on seeing decent returns on their investment. The other way that accounts grow is through compound interest. Compound interest is when interest earned on an account is reinvested. One reason why it's so important to start investing early is that the longer money is invested, the more chance there is that the investor can make significant gains from compound interest.
A traditional 401(k) is based on the investment of pre-tax income into a plan sponsored and administered by employers for the benefit of their employees. All money invested grows tax-deferred. No taxes are paid until the money is withdrawn from the account, which usually occurs during a person's retirement years. Typically, most people are in lower tax brackets during their retirement. Traditional 401(k)s require people to take regular disbursements from their account after they reach the age of 72.
The main difference between a Roth and a traditional 401(k) is that Roth accounts are funded with post-tax money. The account holder puts in money that has already been taxed, but then any withdrawal made during retirement is completely free of any tax burden. This includes money invested by the employee and any profits or compound interest generated by that money.
The easiest way for people to handle 401(k) investments is to choose a target date fund. A target date fund is chosen by the year when the account holder expects to retire. The amount of risk in these funds is set up to be very high for people who are starting their careers because they have time to recover from any market downturns but could reap greater rewards from riskier investments. As the account holder grows closer to retirement age, a target date fund automatically becomes more conservative. Instead of seeking maximum growth, the strategy is now to protect the assets the account holder has built over their working years. However, most funds offer a variety of options, and many people prefer to actively manage their investments. One thing that everyone should be aware of when choosing from available investment vehicles associated with their retirement accounts is fees. Even among a set of choices available within one 401(k) plan, fees can differ wildly. High fees eat away at an account's ability to grow and make the most of the magic of compound interest.
401(k) Contribution Limits
The IRS has strict rules about how much an employee can contribute each year to their 401(k), and there's also a cap on the total amount with employer matches. Due to inflation, the IRS has raised the contribution limits: Most employees could contribute a max of $20,500 in 2022 but could put in $22,500 in 2023. Workers over the age of 50 were eligible to contribute an additional $6,500 in 2022 and $7,500 in 2023. Furthermore, no employee can contribute more than they make, so an additional limit is the employee's salary. Contributions plus employer matches are also limited. These limits are $61,000 in 2022 and $66,000 in 2023 for younger adults; for those over 50, the limits are $67,500 for 2022 and $73,500 for 2023.
Although the IRS does have some rules in place regarding employer matches, each employer has a lot of leeway regarding if they offer a match and how the match works. It's important that employees thoroughly read the plan documents for their specific 401(k). One common restriction is that employers only offer the match to employees who have worked for the organization for a specific amount of time. Sometimes, they also reward long-term employees by offering a more generous match for passing certain employment thresholds. For example, the match might kick in after a year of employment, and a more generous match might be given to employees who have worked for the organization for at least five years.
Generally, the employer matches a certain percentage of the employee's salary. For example, if the company offers a 3% match, then they will match up to 3% of the employee's salary. However, the employee has to contribute at least 3% of their salary to receive the whole match. If they only contribute 2%, then the employer will only match that amount.
Withdrawing From a 401(k)
Those who own a 401(k) must start making minimum withdrawals starting at age 72. However, some people might want to withdraw money from their retirement accounts before they reach the age of 59 1/2, which is the age when account holders can withdraw money without penalties. For most withdrawals made before the age of 59 1/2, the person is responsible for paying a 10% penalty and the withdrawal will be subject to federal and state income taxes based on their current tax bracket. However, the IRS does allow for some withdrawals to be made that aren't subject to the penalty, though they will still be subject to income taxes. These include using the money to purchase a first home or to pay for educational expenses or medical expenses. The plan's administrator also has a say over what counts as a hardship withdrawal, so it's important to consult them before making any decision.
Leaving Your Job
A 401(k) belongs to the employee but is tied to the employer. So what does someone who is leaving an employer do? Sometimes, the best decision is to leave it where it is if the fees on the 401(k) are low. However, most people choose to roll the account over into a 401(k) managed by their new employer so all of their retirement money is together. The other option that can help the account holder avoid penalties and tax implications is to directly roll the account over into an IRA. The good thing about an IRA is that the account owner has much more control over the account. It's very important, though, that 401(k)s be directly rolled over from one investment account into another, or else the account owner may accidentally owe a lot of money to the IRS.