You just got your first job out of college. Congrats! As you go over all of the onboarding information with the human resources department, you’re asked whether you’d like to contribute to a 401(k) retirement savings plan. You’ve heard of 401(k)s before, but retirement seems so far away.
“Do I really want to give up a portion of my paycheck now for something that is decades in the future?” you ask yourself.
The short answer? Yes. Investing in a 401(k) is one of the best things you can do to ensure you’ll have financial freedom once you reach retirement. Below, you’ll find everything you need to know about saving for retirement through a 401(k), from how it works to the myriad benefits.
401(k)s are a type of retirement savings plan offered by both private and public companies of a certain size. A self-employed individual can also contribute to his or her retirement savings with an Individual 401(k), also known as a Solo 401(k) or Self-Employed 401(k).
An employer will offer a 401(k) retirement savings plan to its employees, who can contribute a certain amount of money each pay period. If you decide to contribute to a 401(k), you will pick the types of investments you want in your retirement plan. Most employers will offer at least three investment options, according to the Financial Industry Regulatory Authority (FINRA), though most will offer more.
There are two types of 401(k) accounts: Traditional and Roth. Traditional 401(k) accounts take advantage of pre-tax contributions, meaning the funds you deposit into your 401(k) each year are not considered taxable income for that year and saves you from paying taxes on this amount. The growth in your traditional 401(k) grows tax-free, but withdrawals are taxed as income.
Roth 401(k) accounts have a different tax advantage. Roth 401(k) contributions are after-tax, meaning you’ve already paid income taxes on the funds you deposit to your account. Like the Traditional 401(k), growth in the investments are not taxed. A key advantage the Roth has over the Traditional 401(k) is that withdrawals from the Roth 401(k) at retirement are tax-free. More on withdrawals, and potential penalties, below.
Retirement account investments are usually composed of mutual funds, though they can also include company stock, variable annuities, stable value funds, individual stocks and bonds, and guaranteed investment contracts, FINRA notes.
When it comes time to select your investment options, you’ll want to consider your long-term goals. Typically, you’ll want to go for higher risk investment options with potentially higher returns earlier in your career, as your investments will have more time to grow. If you’re at a later stage in your career and nearing retirement, you’ll likely want to select more conservative investment options.
Many employers will offer matching contributions, which means they’ll match the money you put into your 401(k) account, usually up to a limit. Employee contributions for a Traditional 401(k) and employer contributions are both tax-free, which means both employees and employers benefit from a tax deduction by putting money into a 401(k).
Matching is a fairly simple concept. All it means is that an employer will match your contribution up to a certain amount. For example, if you contribute 2% to your 401(k) each pay period, your employer might match that and also contribute 2%, making your total contribution each pay period 4%.
Most companies that offer matching contributions will match between 1% and 6%. If your company offers matching contributions, you should contribute the maximum amount that they’ll match. After all, if you don’t, you’re leaving free money on the table.
Here’s an example of how company matching works: Let’s say you make $50,000 per year. You contribute 2% of your salary to your 401(k), and your company matches that 2%. You’d be contributing $1,000 per year and your company would be contributing $1,000 per year, bringing the total amount saved each year to $2,000.
This might not seem like a lot of savings, but it adds up over time due to the compounding effect of the annual returns. If you began contributing 2% to your 401(k) plus a 2% employer match at age 22 and retired at age 65, you’ll have saved over $197,000 (assuming 6% average returns), and that’s not accounting for any raises or contribution increases. Note that your employer’s matching contribution can only go into a Traditional 401(k) account, and as mentioned earlier, the funds will grow tax-free but are taxed once withdrawn.
How It Works
After reading the above example, you might be confused about how a 401(k) actually works. Can you access your money while it grows? What happens once it’s time to withdraw it? What about taxes?
When you participate in a Traditional 401(k) plan with an employer, you reap two types of tax benefits: immediately on your income taxes, and over time with the growth of your investments.
Your annual contribution to your 401(k) is deducted from your gross income, saving you income taxes on that amount. (You’re also not taxed on your employer’s match.) Instead of paying Uncle Sam in taxes, you pay yourself with savings!
Your savings then go into an investment account that grows tax-free. Traditional 401(k) contributions are tax-deferred, which means you don’t pay any taxes on the income or on the amount of growth you earn through investments.
Tax-deferred, however, doesn’t mean tax-exempt. You will eventually have to pay taxes on the money, but not until you withdraw that money during retirement. Keep in mind that if you withdraw 401(k) funds early — before age 59 1/2, to be exact — you’ll have to pay income taxes on the early withdrawal money, as well as a hefty penalty of 10% on the amount withdrawn.
There are also stipulations for letting your money sit for too long. Once you hit age 70 1/2, you have to make minimum withdrawals or else you’ll be penalized.
A Roth 401(k) works differently but offers great tax benefits, too. You pay taxes up front on the money you contribute. Then, your account not only grows tax-free but also remains tax-free upon withdrawal so long as you don’t withdraw the funds before you turn 59 1/2.
Below, you’ll find information on some of the primary benefits of saving for retirement using a 401(k).
You Get a Tax Break
Traditional 401(k)s allow you to save money immediately on income taxes. In the above example, you’re able to put away $2,000 each year for retirement. If you had to pay income tax beforehand, you would only be able to invest a fraction of that $2,000 each year.
Roth 401(k)s don’t give you the immediate tax benefit because you deposit after-tax money. But, your Roth 401(k) will grow tax-free and your withdrawals are also tax-free if you wait to dip into your account when you turn 59 1/2. If you’re in a low tax bracket now and think your earnings will only increase including until your retirement, a Roth account could be the best choice for you.
Your Money Will Grow Exponentially
One of the primary benefits of participating in a 401(k) is that your invested money will make gradual returns just by sitting in an account, growing tax-free for as long as your money remains in this retirement account. In the above example in which you save $2,000 of your $50,000 salary each year (including the company match), you’ll have saved nearly $200,000 by the typical retirement age of 65. If you simply put that money into a bank savings account with 2% returns, you would’ve only saved $87,720 — and paid taxes on any interest earned each year.
It’s an Automated, Simple Form of Investing
401(k)s are a great way to save money because they’re easy and streamlined. They’re essentially a “set it and forget” investment. Before you know it, you’ll have saved tons of money for your nest egg without having to put forth too much effort.
If You Take Advantage of Your Company’s Match, You’re Accessing Free Money
We know 2-3% doesn’t seem like a lot, but it adds up over time. If you leverage the maximum company match possible at your job for decades, you’re saving additional money in the realm of tens of thousands of dollars for retirement.
You Can Typically Contribute for as Long as You’re Employed
Our country has changed in drastic ways over the past few decades. Due to a lack of pensions and other types of retirement benefits, many Americans are working longer. One benefit of 401(k)s is that there’s typically no limit to how long you can contribute to them, so long as you’re still working. If you keep working into your late 60s and early 70s, for example, and are eligible to contribute to your employer’s plan, you can keep contributing to your 401(k).
You’ll Have Access to a Loan in a Pinch
One perk of 401(k)s is that you’re able to borrow against yourself in the event that you need a loan. If you need access to cash quickly, say for home repairs or an unexpected medical bill, you can take out a 401(k) loan. The benefits of 401(k) loans are that you’ll likely be able to secure a decent interest rate and you’ll be able to rest assured knowing you’re borrowing from yourself.
However, taking out a 401(k) loan is something you should only consider as a last-resort option. Borrowing against your retirement savings not only means you’re backtracking on your savings goals, but it’s risky: If you lose your job while you have a 401(k) loan taken out, you’ll be required to pay back the loan immediately and you’ll be hit with penalties.
FAQ: Common 401(k) Questions Answered
Retirement savings plans can be nuanced, and therefore you might have some lingering questions. Below, we’ve answered some of the most common questions about 401(k)s.
1. What happens to my 401(k) if I switch jobs?
If you leave your job, you can typically leave your 401(k) savings with your employer and let it grow tax-free until you retire. Most employers only let you do this if the amount is over $5,000. If it’s less than $5,000, the company will likely write you a check for the money or help you move it to an IRA, which is an individual retirement fund. To keep your retirement savings going and to avoid penalties, contact your HR department for the best option, whether it’s to leave your 401(k) at the company or to open an IRA at an investment firm to transfer your savings directly.
You might also have the option to rollover your 401(k) to your new job. All you have to do is ask your new company’s HR contact how to get started. Because people today switch jobs so frequently, it’s typically advisable to rollover your 401(k). Otherwise, you might forget about a decent chunk of money you left with a former employer.
2. How does a 401(k) work once you retire?
Once you hit age 59 1/2, you’ll be eligible for qualified distributions. This means you can get access to your funds in the form of an annuity, which is fixed income paid out on a set schedule. You can also opt to withdraw amounts as you need the money, or as a lump sum.
Just because you hit the eligible age to withdraw funds, however, doesn’t mean you should. Your 401(k) money will continue being invested, so there’s no reason to withdraw it unless you need it.
If you have a Traditional 401(k), the tax advantages end when the money is withdrawn. Each withdrawal is reported to the IRS, and therefore the money you get from your 401(k) or IRA each year becomes taxable income.
Withdrawals from a Roth 401(k) are also reported to the IRS, so be sure to report the income anyway when the time comes — even though qualified Roth withdrawals are tax-free.
By this time, you’ve saved diligently over the years. Consider consulting with a financial planner or adviser to optimize your income strategy once in retirement. A good financial planner can help you create a sustainable income flow, minimize your tax burden and match your investments with your goals.
3. What are the 401(k) contribution limits?
The maximum contribution limit for a 401(k) in 2019 is $19,000. This is the maximum amount you personally can contribute, meaning it does not include a company’s match.
401(k) policies also allow for catch-up contributions, which apply to those who are older and are looking to save more aggressively. People who are over 50 years old can contribute a maximum of $25,000 each year, which is an additional $6,000, as part of this catch-up contribution rule.
4. How much should I contribute to my 401(k)?
A good rule of thumb is to contribute at least 10% of your annual income toward your 401(k). If you can’t contribute this much, don’t worry. Just make sure you contribute at least what your company is matching, and be sure to increase your contributions each time you get a raise.
5. How do you borrow money from your 401(k)?
If you decide you’d like to borrow against your retirement savings in the form of a 401(k) loan, you’ll want to get in touch with the HR contact at your job, or read about how 401(k) loans work on your company’s 401(k) provider’s website.
All in All
If you’re wondering, “How does a 401(k) work?”, you’re likely at the beginning of your journey toward incorporating better personal finance habits into your life. One of the biggest mistakes people make is not thinking long-term about their retirement savings strategy. But by reading about how to save for retirement now, you’re on the right track.
After all, focusing on retirement planning at a young age allows you to grow your wealth steadily and efficiently so that you can achieve financial freedom in your golden years. If you’re ready to learn more about how to save for retirement, check out this simple and easy-to-follow five-step guide.