What is a 401(k) Plan? How Does it Work?

If you have a 401(k) plan at work, it may be your easiest and best way to save for retirement. Most employers will automatically take money out of your paycheck to put into your 401(k) account and many will also match some or all of what you contribute. Here are answers to some of the most common questions about 401(k) plans.

How Much Can You Contribute to Your 401(k)?

Top takeaway: Kick in as much as you can afford to, and at least enough to grab any employer match.

The maximum amount that you can contribute to your 401(k) plan each year changes periodically, based on adjustments to the cost of living. For 2017, for example, the maximum is $18,000 for anyone under 50. If you are 50 or over, you can contribute up to $24,000.

In addition, the company you work for may also contribute to your 401(k) account through what’s known as an employer match. For example, your employer might add 50 cents or $1 for every $1 you put in, up to a certain amount. So, if you contribute $18,000 over the course of the year, and your employer matches 50% of that, you’ll end the year with $27,000 in total contributions. The maximum that you and your employer can collectively contribute is either $54,000 ($60,000 if you’re over 50) or an amount equal to 100% of your compensation, whichever is lower. Again, these are the numbers for 2017 and could change in the future.

We suggest contributing at least enough money to your 401(k) plan each year to get your full employer match. Think of it as like getting a raise, and one you typically won’t have to pay taxes on for years.

If you are self-employed, you can establish an individual 401(k) plan just for yourself. The maximums are the same as mentioned above ($18,000 or $24,000, depending on your age). Plus, because you are your own employer, you can also make employer contributions to your account. The maximum is 25% of your net earnings from self-employment, and your total employer and employee contributions can’t exceed $54,000, or $60,000 if you’re over 50.

Finally, if you have fully funded your 401(k) and want to save even more for retirement, check if you’re eligible for an IRA. There are also several other investment accounts to consider.

What Can You Invest in?

Top takeaway: Be sure to diversify, either through several types of funds or one target-date fund.

Your plan will probably offer you a fairly wide choice of investments for your 401(k) contributions. Those might include a menu of stock and bond mutual funds, money-market funds, guaranteed investment contracts (GICs), and other vehicles. One recent survey found that employers offered 25 investment options, on average.

For the safety of diversification, you can spread your contributions among several different kinds of investments, such as putting a certain percentage in stock funds and a certain percentage in bond funds. As a general rule, stocks offer greater potential for gains than bonds do, but at a greater risk.

Another, often easier, way to diversify is by investing in a target date fund. These funds hold a portfolio of investments based on the year you expect to retire. For example, if you are decades from retirement, the fund may invest more in stocks and less in bonds than a target date fund for someone whose retirement is just a few years off. Target funds are also supposed to adjust their investment mix over the years, becoming less risky as their target date, and your retirement, approaches.

Still another option you might have in your 401(k) plan is the opportunity to buy shares of stock in the company you work for, sometimes at a discount. The company might also use its stock for your employer match. As a general rule, financial experts suggest keeping no more than 10% of your account in employer stock. Otherwise, if something bad happens to your company in the future, you run the risk of losing both your job and a substantial chunk of your retirement savings.

What Are the Tax Benefits of a 401(k)?

Top takeaway: You can choose between a tax break now or later, depending on your situation.

The money that comes out of most employees' paycheck to fund a traditional 401(k) account isn’t taxed until you eventually withdraw it. The interest and dividends that your account earns will also grow on a tax-deferred basis and not be taxed until you withdraw them.

If you’re offered the choice of a Roth or regular 401(k), consider whether you’d prefer your tax break now or after you retire. With the Roth version (offered by some employers), you don’t receive any tax benefit from contributions to your account, but the money you later withdraw is tax-free if you meet certain requirements. Note that if your employer allows it, you can hedge your bets and have both types of accounts. However, your combined contributions to them can’t exceed the maximums mentioned above: $18,000 if you’re under 50, or $24,000 if you’re 50 and up.

You might opt for a regular 401(k) if, for example, you expect your income to drop when you retire (as is true for most people). The deduction will help reduce your taxes now, and your 401(k) withdrawals years from today are likely to be taxed at a lower rate than you are currently paying. But if your income is lower now than you expect it to be in retirement, it could be smart to forgo the immediate tax deduction, which might not be worth much anyway, and enjoy tax-free income from a Roth 401(k) after you retire. That could be the case if you’re just starting out in your career and making a relatively low entry-level salary.

When and How Can You Withdraw Money from your 401(k)?

Top takeaway: Beware of taking money too soon or too late.

Because 401(k)s are intended for retirement savings, the rules are written to encourage you to keep your money in the account until that day comes. So until you reach age 59½ you’ll not only pay income tax on any money you withdraw but an additional 10% penalty. What’s more, your employer is required to withhold 20% of your payment to cover federal taxes, so a $10,000 early withdrawal would only net you $8,000. If you needed $10,000 in cash, you’d actually have to withdraw $12,500 to make up for the withholding.

There are exceptions to the penalty, however, for circumstances the IRS considers a financial “hardship.” Those include:

  • If you suffer a total and permanent disability.
  • If you have significant unreimbursed medical expenses. By “significant,” the IRS means greater than 7.5% of your adjusted gross income if you are 65 or over, or 10% if you are younger.
  • If you leave your employer and are at least age 55. The minimum age drops to 50 if you qualify as a public safety employee for certain federal, state, or local agencies.
  • Regardless of your age, if you have left your employer, you may be eligible to make penalty-free withdrawals in the form of series of substantially equal payments over at least five years or until you turn 59½, whichever comes later. The amount of these withdrawals is based on your life expectancy or the life expectancies of you and your designated beneficiary on the account.

Bear in mind that any money you withdraw from your 401(k) for these purposes means you’ll have that much less saved for your retirement someday. For example, suppose you withdraw $10,000 at age 30 to buy a first home. If you’d left the money in your 401(k) instead, and it earned even a relatively modest interest rate of 5% a year, it would grow to more than $55,000 by the time you reached age 65.

401(k) Loans

You may also be able to take a loan from your 401(k) plan, if your employer allows it. The IRS requires that the rate be “reasonable”—that is, in line with what you might pay at a financial institution. In practice, many employers charge an amount equal to the prime rate plus one or two percentage points. So if the prime rate is 3.75%, as it was in early 2017, your loan rate might be 4.75% or 5.75%. In general, you’ll have to pay the loan back within five years and repay it immediately if you leave your employer. That can be a problem if, for example, you lose your job unexpectedly.

Required Withdrawals

Once you reach age 70 1/2, you will generally be required to start making withdrawals from your 401(k), and paying taxes on them, following an IRS formula based on your age and life expectancy. The IRS explains these required minimum distribution, or RMD, rules on its website and has tables showing how much you’re supposed to withdraw each year. The rules are worth heeding: The IRS imposes a hefty 50% tax penalty on any amount you should have withdrawn but didn’t. That’s known as an excess accumulation.

So, for example, if your RMD for the year is $20,000, but you only withdrew $12,000, your excess accumulation would be $8,000, and your tax on that would be $4,000. Had you instead withdrawn the $8,000, you would only have paid regular income tax on it, an amount ranging from 10% to 39.6%, or $800 to $3,168, at current tax rates.

Note that Roth 401(k)s are also subject to required minimum distributions, unlike Roth IRAs, which are not. However, Roth 401(k) withdrawals, like those from a Roth IRA, can still be tax-free if you are at least 59 1/2 and have had the account for a minimum of five years.

What Happens to Your 401(k) Funds If You Change Jobs?

Top takeaway: Follow the rules to preserve your 401(k)’s favorable tax status.

If you leave your job, you’ll generally have three options for your 401(k) plan: Keep it with your current employer, move it into your new employer’s 401(k) plan, or roll it over into an IRA at a mutual fund or brokerage company. None of these choices, done properly, should interfere with your account’s tax-deferred status or trigger any immediate taxes. You could also cash in the account, but you’ll owe taxes and possible penalties, as well as have less money available for retirement. In other words, this is a very bad idea unless you absolutely need the money then and there.

Leaving your account where it is may make sense if you have been happy with the way the plan is run. Not all employers offer this option, however, especially for accounts with relatively small balances. If you do this, be sure to notify your ex-employer whenever your address changes—and don’t forget you’ve left that money behind.

401(k) Rollovers

Rolling your 401(k) into your new employer’s plan might be an option if you don’t want to leave the account with your ex-employer because you weren’t satisfied with how it was run but aren’t comfortable managing it yourself. Again, not all new employers will do this, so you’ll need to check first. An IRA rollover could be your best move if want more control over how and where your money is invested. Note, though, that the IRS has strict rules on rollovers, and if you don’t follow them, the money in your account could become immediately taxable and possibly subject to additional penalties.

One generally safe option is a direct rollover, in which your current 401(k) plan administrator makes the payment directly into an IRA or your new employer’s 401(k). Your current plan administrator can tell you how to proceed; the administrator or investment company where you are moving your money may also be able—and even eager—to offer assistance.

Vested 401(k) Balances

Another consideration for job changers is what’s known as vesting. That refers to who owns the money in your 401(k) account. All of the contributions you make are immediately vested, so they’re yours to take with you if you leave your employer. Your employer’s contributions, however, don’t belong to you until they have also vested. Employers can follow different vesting schedules, depending on the terms of their plan. In some plans, employer contributions vest immediately, while in others it can take up to six years before they become 100% vested.

So before you quit your job, check on your employer’s vesting schedule. If you time your departure right, you could walk away with more money for your retirement.

Sources

401(k) Distribution Rules
Rollovers of Retirement Plan and IRA Distributions

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