Your retirement plan can be the cornerstone of your financial future, but it can also be very confusing. What exactly is a 401(k) plan, and how does it work? How do you choose which investment options to pick from when you set up your account? What happens if you change jobs in the middle of your career? This guide on your retirement plan, also known as a 401(k) plan, will give you all the information you need to make smart decisions about your retirement savings accounts.
What is a 401(k)?
A 401(k) is a type of retirement plan sponsored by employers. It allows employees to set aside a portion of their income before taxes are taken out to invest for the future. When your savings grows more quickly and you’re not paying taxes on it immediately, you can save more. For example, an employer may match some of your contributions, which can result in you saving even more.
Once you reach retirement age, you can start making withdrawals from your 401(k). If you wait until after reaching age 59 1/2, you won’t have to pay taxes on those distributions. However, if you need access to that money before then, there are penalties for early withdrawal. You’ll also have to pay taxes on that money as normal income. Depending on how much of your contributions and returns your employer has contributed will dictate how much of your savings is available for withdrawal. After that’s gone, though, everything else left over—your total balance minus any matching amounts from employers—becomes yours outright without penalty or taxation.
How Does it Work?
The 401(k) was created by the United States Congress to encourage Americans to save for retirement. A number of the benefits it offers is tax savings.
There are two types of trusts, each with their own tax-saving potential.
A traditional 401(k) deducts employee contributions from gross income, meaning the money comes straight from the employee’s paycheck before income taxes are taken out. Thus, the employee’s taxable income is reduced by the total amount of contributions for that tax year and can be reported as a tax deduction. In most cases, employee contributions and earnings are tax-free until the employee withdraws the money in retirement.
Roth 401(k) contributions are deducted after tax from the employee’s income, which means there is no tax deduction for the year of the contribution. Withdrawals upon retirement will result in no additional taxes on the employee’s contribution or the investment earnings. Roth options aren’t available to all employers; if they are offered, employees can choose either one or mix them, up to the annual limits for tax-deductible contributions.
Why Should I Contribute?
Employees who contribute to a 401(k) plan can lower their taxable income by the amount they contribute, up to the IRS limit. This decreases the number of taxes you have to pay each year. For example, if you earn a salary of $50,000 and contribute $5,000 to your 401(k), you will only be taxed on $45,000 of your salary. In addition, the money in your account grows tax-deferred until you withdraw it at retirement. This means you won’t have to pay taxes on any investment gains until you take the money out.
A key benefit of using your 401(k) plan as an investment vehicle is that you can often choose from a variety of investment options, including company stock. If you’re offered company stock in your 401(k), and it represents a large percentage of your portfolio value, be sure to check on potential conflicts of interest before choosing it as an investment option. For example, if you know that certain managers have significant ownership in certain stocks, it could potentially influence their decisions about which stocks to recommend for inclusion in your account. You may also want to look into other options that don’t involve company stock but still give you good exposure to different types of investments.
Who Can Open an Account?
Employees who work for a company that offers a 401(k) plan can open an account. Employees can typically contribute up to $18,500 per year ($24,500 if you’re 50 or older). Employers may also make matching or nonelective contributions to your account. You don’t pay taxes on the money you contribute or on the earnings it grows until you withdraw it at retirement.
If you’re self-employed, it’s generally worth setting up your own retirement plan, such as a SEP or SIMPLE IRA. You can contribute up to $19,000 annually and still maintain eligibility for an itemized tax deduction on your taxes. However, these plans aren’t mandatory—you’re free to put your money in other accounts as well. If you do set one up, make sure it’s through a company that specializes in small business plans so that you get professional guidance and legal protections while keeping costs low.
Are There Fees?
Yes, there can be fees associated with a 401(k) plan. These fees can come from the investment options within the plan or from the plan itself. It should be noted that fees will also differ by provider. However, there are ways to minimize the fees you pay. For example, you can choose lower-cost investment options or you can negotiate with your provider.
Keep in mind that fees will vary depending on where you are in your career. If you’re just starting out, for example, and only have limited funds available for retirement savings, you might want to choose a provider offering low-cost options. If you’re nearing retirement age, however, you might be more willing to pay higher fees for greater flexibility so you can meet all of your financial needs. Also remember that these fees may be tax deductible if they apply toward paying into your plan.
Traditional 401(k) vs. Roth 401(k)
A traditional 401(k) plan was the only 401(k) option available to employees and employers in 1978. Roth 401(k) plans followed in 2006. The Roth IRA is named after former U.S. Senator William Roth, the primary sponsor of the 1997 legislation which created the Roth IRA. Roth 401(k)s were slow to hit the scene, but now many employers offer them. So employees usually have to choose between traditional and Roth 401(k).
It might be wise for people who expect to be in a lower tax bracket after retirement to take advantage of a traditional 401(k) and its immediate tax break. With that said, those who want to be in a higher tax bracket in retirement might opt for the Roth IRA, so that they can avoid taxes on their savings in the future. Also important – especially if the Roth IRA has years to grow – is that there is no tax on withdrawals, which means that all the money the contributions earn over decades of being in the account is tax-free.
In terms of being practical, the Roth reduces your current spending power more than a traditional 401(k) plan. This is an issue if you are currently running tight on money. Given that nobody can know what tax rates will be decades from now, neither type of 401(k) is a sure this is why many financial advisors recommend that people hedge their bets by investing some of their money in each.