Contributing to a 401(k) is extremely valuable as you plan your long-term retirement goals. Over time, you can develop investment strategies in order to optimize your 401(k).
Here, we’ll cover key aspects of how your 401(k) can contribute to your nest egg, whether you’re just getting started or are nearing retirement.
What Is a 401(k) Plan?
One of the most common investment vehicles, a 401(k) plan is a tax-advantaged, employer-sponsored plan that allows you to save for retirement in a tax-sheltered way to help maximize your retirement dollars. Sometimes, your employer may even contribute to your plan, essentially free money.
How a 401(k) Works
Typically, you have income taxes withheld from the money you earn as an employee. A 401(k) plan allows you to accomplish two goals:
- Invest your money for retirement
- Avoid paying income taxes in the current year on the amount of money that you put into the plan, up to the 401(k) contribution limit
The money grows tax-deferred inside the plan, meaning you don’t have to pay tax on gains until you take money out of the plan. The most you can invest in your 401(k) depends on your plan, your salary, and government guidelines. This IRS-set limit is $20,500 in 2022.
How Do You Get a 401(K)?
401(k) plans are only offered by employers; if you don’t have access to a 401(k) at your workplace, you can’t participate in one. Talk to your human resources department to find out whether your company offers a 401(k) plan and, if so, how you can join.
If your company doesn’t offer a 401(k), that doesn’t mean you can’t reap 401(k)-style retirement and tax benefits. You can still open an IRA on your own. IRAs offer the same opportunity to save for retirement with tax advantages.
401(k) Employer Matching
Employer matching of your 401(k) contributions means that your employer contributes money to your retirement savings plan. If you are not able to max out contributions, then try to contribute at least enough to take advantage of your employer’s matching contributions to your 401(k).
Here are the common types of employer matches.
Partial matches are when your employer will match part of the money you put into your 401(k), up to a certain amount. For example, your employer may offer a partial match of 50% of what you contribute, up to 6% of your salary.
Let’s say you earn $100,000 per year. Your matching-eligible contribution amounts are 6% of your salary, or $6,000. But since your company only offers a 50% partial match, they will match half of the $6,000, or $3,000. So to get the maximum amount of 401(k) match, you have to put in 6%. If you put in more, say 10%, your employer will still only match half of 6% of your salary. The employer has the ability to determine the matching parameters.
Dollar-for-Dollar Matching (100% Match)
Dollar-for-dollar matching is when your employer puts in the same amount of money you do, up to a certain amount. An example of dollar-for-dollar is up to 5% of your salary. In this case, if you put in 5%, they put in 5%; if you put in 2%, they put in 2%. If you put in 6%, they still only put in 5%, because that’s their maximum contribution.
Be sure to check on your company’s 401(k) vesting policy. While some employers immediately transfer the ownership of matched funds, others may delay the transfer for several years in order to support employee retention.
Withdrawing from Your 401(k)
To begin, 401(k) plan rules may not allow you to take regular withdrawals unless one of several events has occurred. Some examples include turning age 59½ or leaving your job.
Taking a distribution from your 401(k) prior to turning 59½ may cause you to owe federal income tax, state income, and other related tax, and a 10% penalty on the amount you withdraw. You may be able to withdraw penalty-free from your current employer’s 401(k) if you retire after age 55 from the employer where the plan is currently in place.
Once you reach the age of 59½, the IRS allows you to take penalty-free withdrawals from your retirement accounts. Due to the SECURE Act, Required Minimum Distributions (RMDs) are required after someone turns 72 years of age.
Can I Withdraw Early?
In most cases, you’ll have to be at least 59½ years old before you can withdraw from your 401(k) without a penalty. However, there are several situations where the IRS allows you to withdraw early. For example, you can take a hardship withdrawal to pay for unreimbursed medical expenses or to prevent an eviction. Here’s a list of situations where you can take penalty-free hardship withdrawals from your 401(k):
- Medical expenses for the employee, spouse, or dependent
- Purchase of a principal residence
- Tuition and fees for the employee, spouse, or dependent
- Payments to prevent an eviction
- Funeral expenses for the employee, spouse, children, or dependents
- Expenses to repair damage to a principal residence
In addition to those withdrawals allowed for financial hardship, there are several other situations where you can make an early withdrawal from a 401(k) without the 10% penalty. Those situations include the death or disability of the participant, to pay for unreimbursed medical expenses, if you’re taking a series of substantially equal payments, or if you have a separation from service during or after age 55.
Required Minimum Distributions
We’ve discussed how the IRS discourages withdrawals from a 401(k) before age 59½. But what may come as a surprise is that there’s an age where the IRS requires that you start withdrawing funds from the account.
Once you reach age 72, you’ll have to start taking required minimum distributions (RMDs). The amount you’ll have to withdraw is based on the balance at the end of the previous calendar year. You can find your RMD using the IRS’s Uniform Lifetime Table.
The amount you withdraw each year — including any RMDs — will be included in your taxable income and subject to income taxes. If you aren’t prepared to spend these funds, you can simply reinvest them in a taxable brokerage account. You also have the option of rolling the money into a Roth IRA, since those accounts aren’t subject to RMDs. Finally, you can use a qualified charitable distribution to donate the money to charity and avoid paying income taxes on those dollars.
Another way to access the funds in your 401(k) — at least temporarily — is to use a 401(k) loan. With this type of loan, you can borrow up to 50% of the balance of your 401(k) plan, up to $50,000. You’ll have to repay the full balance with interest within five years.
There are a few downsides to relying on a 401(k) plan. First, employers aren’t required to allow 401(k) loans, meaning it may not even be an option for you. Additionally, if you leave your job while the loan is outstanding, you may be required to repay the full amount immediately. Finally, when you take money from the account, it’s no longer growing, which takes away money from your future financial needs during retirement.
In 2022, the IRS allows workers to contribute up to $20,500 to their 401(k) plans, up from $19,500 from the previous year. There’s also a catch-up contribution of $6,500 allowed for individuals age 50 or older, allowing for up to $27,000.
Remember the $20,500 limit only applies to contributions made by a plan participant. Your employer can also contribute to the 401(k) plan on your behalf, and those contributions don’t count toward your $20,500 limit. Instead, there’s a total limit of $58,000 for both employee and employer contributions. For those over age 50 who make catch-up contributions, the total limit is $64,500.
Say for example you decide to leave your employer in the future. You may be inclined to just leave your money in the old employer’s 401(k) plan and not touch it as a way for you to have it “out of sight, out of mind.” Here are reasons to rethink that approach.
Potentially Gain More Investing Options
While leaving money behind in a former employer’s 401(k) might be the easiest thing to do, it’s not always the best option. One of the main benefits of a 401(k) plan is an employer match if the company offers one.
Once you leave a job where you have a 401(k), you no longer receive the company’s contribution or match. 401(k) plans tend to have high fees, limited investment options, and strict withdrawal rules. If the old 401(k) was rolled over to a different vehicle like a traditional or Roth IRA, you may have more control over the investment strategy.
Roll Over Your 401k Into a New 401(k) or IRA
If your new employer offers a 401k plan with low costs and a wide variety of investment options, this might be a viable option to consider. What could be an even better option though is to roll over your old plan into a Rollover IRA. 401(k)s can be costlier than IRAs, mostly if they come with an extra layer (or layers) of fees, and can be lacking in investment options like low-cost ETFs.
You or your advisor can choose among thousands of ETFs, bonds, mutual funds or individual stocks in an IRA. By law, 401(k) plans can offer as few as three investment options. Mutual funds are not only expensive, but also tend to underperform the market. ETFs, on the other hand, provide a relatively low-cost, tax-efficient way to create a well-diversified portfolio. Low-cost investments help boost your retirement security – without having to ramp up savings or portfolio risk.
Types of 401(k)s and Retirement Accounts
Investing and saving for retirement is not a straightforward, easy task. There are endless variables such as life stages, personal goals, varying living costs, and different types of investment vehicles that can become overwhelming.
In addition to 401(k) options, there is a broad range of retirement investment vehicles:
However, when it comes to your 401(k) plan, there are primarily two options: Traditional 401(k) and Roth 401(k).
Traditional 401(k) contributions are made with pre-tax dollars, ultimately reducing your taxable income and allowing your contributions to grow tax-deferred until you withdraw your money in retirement.
Who Is It Good For?
Traditional 401(k)s can potentially be more beneficial if you think you will be in a lower marginal tax bracket when you start withdrawing funds in retirement.
In contrast, Roth 401(k) contributions are made with after-tax dollars. This option gives you tax-free growth and — as long as you follow the rules — fully tax-free withdrawals once you reach 59½ and if the individual account has been in place for at least 5 years.
Who Is It Good For?
Roth 401(k)s are typically good for people who think they will be in a higher tax bracket in the future because of the tax-free withdrawals in retirement. What’s more, you can avoid RMDs by rolling the plan into a Roth IRA upon reaching age 59½ or leaving your employer. For these reasons, Roth IRAs can be an effective legacy planning tool.
Here are a few common questions about 401(k)s.
Should I Invest in a 401(k) Even if I Have an IRA?
Even if you have an IRA, investing in your 401(k) could be a smart move for your nest egg. Both workplace 401(k) plans and individual retirement accounts represent important building blocks in your retirement savings. Supplementing your workplace retirement account is a great way to boost your retirement savings accounts and put even more of your money to work in tax-advantaged accounts.
How Much Should I Contribute to My 401(k)?
This is an important question, and the answer varies based on each individual’s personal financial circumstances. In 2022 the contribution limit for a 401(k) is $20,500. If you are over the age of 50, then you can contribute up to an additional $6,500 per year. It’s important to note that employer matching contributions don’t count toward this limit, but there is a limit for employee and employer contributions combined: Either 100% of your salary or $57,000 ($63,500 if you’re over 50), whichever is greater.
Should I Max Out My 401(k)?
Generally, the more you can contribute, the better. However, situations arise where you may need to prioritize your cash savings in your emergency fund or save for a different reason, such as for a home down payment or a new car. If your employer offers matching, try contributing at least the required amount in order to take full advantage of the match.
The Bottom Line
A 401(k) plan is a type of employer-sponsored retirement account offered at many companies in the United States. It’s the most popular retirement plan offered by employers, and often the first exposure to wealth building for American workers.
If your employer offers a 401(k) plan, taking advantage of it — especially if there’s a matching contribution available — can go a long way in helping you to prepare for retirement. However, it’s important to understand all of the rules and limitations on these plans before making a contribution.