What’s a 401(k)? (Everything You Need to Know)

Last updated on February 19, 2024

In recent years, the traditional company pension plan has become rare in America. Instead, many workers rely on 401(k) plans for their retirement savings. It’s essential to grasp the basics of how these plans work and how to make the most of them.

What is a 401(k): Key Takeaways
1. A 401(k) is a defined-contribution retirement account.
2. You contribute pre-tax dollars and enjoy tax-deferred growth.
3. Employer matches are a significant benefit – take full advantage.
4. Asset allocation should consider your age and risk tolerance.
5. Be mindful of investment fees, as they can impact returns.
6. Contribution limits for 2021 are $19,500, with a $6,500 catch-up option.
7. Penalty-free withdrawals usually begin at age 59 ½.
8. Required Minimum Distributions (RMDs) start at age 72.
9. Consider direct rollovers when changing employers.
10. Roth 401(k)s offer tax-free growth and withdrawals.

☞ What Is a 401(k)?

A 401(k) is a type of retirement savings account offered by many employers. It’s different from old-style pensions. With a 401(k), you and sometimes your employer contribute money regularly.

This money is then invested, typically in things like mutual funds or stocks. Over time, your investments can grow, which helps you save for retirement.

Why Save with a 401(k)?

401(k)s come with several advantages:

  • Easy Enrollment: Many companies automatically sign up their employees for a 401(k) plan. If you don’t want to join, you can choose not to.
  • Tax Benefits: With a traditional 401(k), you use money from your paycheck before taxes. It means you pay less in income tax now. Plus, your investments grow without being taxed, so you save money in the long run.
  • Employer Match: Some employers will add extra money to your 401(k) if you contribute a certain amount. This is like free money for your retirement.
  • Compound Interest: Starting to save early is essential. When you invest your money, it can earn more money over time. The earlier you begin, the more you can potentially earn through compound interest.
  • Lower Taxes in Retirement: You typically pay taxes when you withdraw money from your 401(k) during retirement. This can be advantageous because, in retirement, you might be in a lower tax bracket than when you were working.

How to Make the Most of Your 401(k)

Experts recommend saving at least 15% of your paycheck for retirement. But if that’s too much, start by saving enough to get the full employer match. That way, you’re not missing out on the free money your employer offers.

One thing to note: In some cases, you won’t immediately own all the money your employer contributes. You might need to stay with your company for a certain time to “vest” and fully claim those funds.

Remember, the sooner you start saving in your 401(k), the better off you’ll likely be in retirement. So, don’t wait—take advantage of this valuable tool to secure your financial future.

☞ How to Invest Your 401(k) Wisely

401(k) plans offer flexibility when it comes to investing your money. While your employer or plan administrator might offer some guidance, the choices are mostly up to you.

Here’s how to make the most of your 401(k) investments.

Types of 401(k) Investments

Most 401(k) plans provide a range of investment options, with mutual funds being the most common. These funds pool money from many investors to buy a mix of stocks or bonds.

Some plans also allow you to invest in exchange-traded funds (ETFs), which are similar to mutual funds but traded throughout the day.

Within your 401(k), you’ll often find index funds. These funds aim to match the performance of major market indices, like the S&P 500. They offer a straightforward way to invest in the overall market.

How to Build Your 401(k) Portfolio

Experts recommend diversifying your investments by including both stocks and bonds. If you’re younger, you can typically afford to take more risks by having a larger portion of your 401(k) in stocks. Stocks can be volatile, but over time, they often offer higher potential for growth.

As you get closer to retirement, it’s usually a good idea to shift to a more conservative mix. This might mean more bonds and larger, stable stocks, ETFs, or mutual funds that pay dividends. These investments provide some growth potential while offering a steady income.

If you prefer a hands-off approach, consider target-date funds. These automatically adjust your investments to become more conservative as you approach retirement age.

401(k) Fees

Fees can impact your 401(k) returns over time, so it’s crucial to be aware of them. While fees on mutual funds and ETFs have generally come down, they can still affect your bottom line.

Pay attention to the fees associated with each fund in your 401(k) plan. While you might not have complete control over the fund options, you can choose lower-cost options when available. This way, you can keep more of your hard-earned money working for your future.

401(k) Contribution Limits

The IRS sets annual limits on how much you can contribute to your 401(k). For 2023, the limit is $22,500. If you’re 50 or older, you can contribute an additional $7,500.

These extra contributions, often called “catch-up” contributions, can help boost your retirement savings if you didn’t save enough when you were younger or need more for your later years.

401(k) Withdrawals

You can start taking money from your 401(k) without penalties when you reach 59 ½ years old. By the time you’re 72, you must take required minimum distributions (RMDs) from your account. However, there may be exceptions if you’re still working.

RMD amounts depend on your account balance and life expectancy estimates. Taking money out of your traditional 401(k) before 59 ½ usually results in a 10% early withdrawal penalty plus income taxes.

This means you lose both money and the potential for growth. Experts typically advise against early 401(k) withdrawals.

Rolling Over Your 401(k)

If you change jobs and your new employer offers a 401(k) plan, you can transfer your funds into the new plan. It’s best to do this as a direct transfer, rather than receiving a check.

If you take more than 60 days to complete the rollover, the IRS may consider it an early withdrawal, subject to taxes and penalties.

Upon retirement, you must decide whether to keep your money in your former employer’s 401(k) or roll it over into an Individual Retirement Account (IRA).

This decision requires careful consideration. An IRA can offer more diverse and flexible investment options, including access to asset classes not commonly available in 401(k) plans.

However, if your previous employer had a low-cost 401(k) with good options, it might make sense to stick with it. If you’ve worked for multiple employers during your career, rolling all your retirement accounts into a single IRA can simplify your financial planning and provide a clearer picture of your financial health.

Starting a 401(k) Without an Employer

401(k)s are typically employer-sponsored accounts, so you can’t open one independently. If your job doesn’t offer a 401(k), consider opening an Individual Retirement Account (IRA) and contributing to it.

However, if you’re self-employed, you may be eligible for a one-participant 401(k) plan, also known as a Solo 401(k).

Traditional 401(k) vs Roth 401(k)

Roth 401(k)s differ from traditional ones because they are funded with after-tax dollars, not pre-tax. The money then grows tax-free, and you won’t be taxed on withdrawals in retirement. However, contributions made by your employer are taxable when withdrawn.

Experts recommend Roth 401(k)s for younger workers who likely have lower current income and tax rates than they will in the future when they reach their peak earning years.

⬇️ More from thoughts.money ⬇️

Pavlos Written by:

Hey — It’s Pavlos. Just another human sharing my thoughts on all things money. Nothing more, nothing less.