What is a 401(k)?
Over 100 million Americans rely on 401(k)s to secure their financial future. But what’s a 401(k), and how does it work?
A 401(k) is a type of defined contribution plan, where you make regular, pre-tax contributions from your paycheck to a plan your employer offers. This may sound a bit technical, but once you sign up, it’s simple and seamless. Just think of it as part of your pay that, instead of going to your bank account, goes toward an investment in your future. We’ll talk more about the process in a moment.
The term 401(k) itself originated from Internal Revenue Code Section 401(k) as part of the Revenue Act of 1978. Since then, these plans (and the 403(b) plans for those working at nonprofits and the government) have become key vehicles for saving for retirement. Americans are saving more than $8.5 trillion in combined 401(k) and 403(b)s.
How does a 401(k) work?
401(k)s work easily. If your employer offers a plan, there’s an enrollment period during which you choose the percentage of your salary you want automatically deducted from your paycheck, tax free, and put into the plan. This money (up to the current maximum of $23,000 per year for those under age 50, $30,500 for those 50+) is then invested in funds available through your plan.
What is an employer match contribution?
Another advantage of a 401(k) is what’s known as the “employer match.” It’s basically free money from your company. If they offer it, your 401(k) contributions up to a certain amount are matched by them. For example, an employer might match 100% of your contributions up to 4% of your annual income. So, if you make $50,000 a year, and you contribute 4% of your salary ($2,000), your employer would match your contributions and give you up to $2,000 for your 401(k). However, there’s one important thing to note about the employer match – “vesting.” Vesting is a fancy way of saying when the employer match becomes yours. Typically, employers require three to five years for you to receive the full employer match. If you leave the company before then, it may have an impact on the vesting. But don’t worry: the money you contributed to your plan will always be yours.
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Get startedWhat happens to my 401(k) if I leave my job
If you leave a job and start a new one, you’re going to have to make a decision about what to do with your 401(k). The two main options are to move your investments over to your new employer’s 401(k) plan or roll it over to an individual retirement account (IRA). There are reasons for each choice. By moving your 401(k) to an IRA, you have greater control over your portfolio, greater investment choices, likely lower fees and fewer rules, among other benefits. By moving your 401(k) to your new employers’ 401(k) plan, you are keeping your retirement accounts together, which may make them easier to manage. A third option is to keep it in your old plan – but this depends on what your balance is and the rules of that plan itself.
When Can I Use the Money in my 401(k)?
Fast forward to retirement. You’ve been regularly contributing to your 401(k) and you’ve developed a nice nest egg. So, what now? If you retire any time after you reach age 59½, you can start withdrawing money: either through non-periodic withdrawals or a lump-sum payment.
If you need to take money out before you are 59 ½, you should know there are rules. First, there is a 10% penalty from the IRS (with certain exceptions) for taking money out before you retire. Second, once you reach 72 or 73 (depending on when you were born), you’re required to begin taking money out of the plan.
This is a lot to digest, especially if 401(k)s are new to you. This is why it’s good to talk to a financial advisor or your plan provider about your specific questions.
While retirement may seem far away, planning is something that you should start as soon as you can. Even if you put just a small amount away now, those contributions, over time, can add up. If you plan correctly and make the right decisions, you’ll be in the best position to have a relaxing and rewarding retirement.
We would love the opportunity to help you plan for a happy retirement at PensionBee. Please let us know if we can help to answer any questions for you. Be Retirement Confident!
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.
