Senior man with his son and grandson, laughing.

Pensions are becoming increasingly rare. In their place, employers have started plans which are at least partially employee-funded and are often even self-directed. The issue is there are so many options for workers it can be difficult to get your head around it all. First, there’s the alphabet soup problem: IRA, 403(b), etc. Then you have to decide whether you want to contribute pretax or after-tax funds.

Employers offer many options so their employees can save a nest egg for the future but knowing which one to choose can require significant research. It’s never too early to start thinking about retirement and savings for the future, so it’s important to consider the investment vehicle you’re going to put your money in. Today, we thought we’d take a look at the plan that sort of got all the self-funded retirement investments started: the 401(k).

What Is A 401(k) Plan?

The 401(k) started out as a section in the Revenue Act of 1978, allowing employees to defer compensation from bonuses and stock options without having to pay taxes up front on the money. This later started allowing employees to contribute to the plan through salary deductions. Occurring in 1981, this change transformed the 401(k) into the major retirement savings vehicle we know today.

A 401(k) is a retirement savings account that’s sponsored by your employer in the vast majority of cases, although you can get a 401(k) if you’re self-employed. All 401(k)s are tax-advantaged, meaning at some point or another your investment is receiving special tax benefits not available through regular savings accounts.

The tax advantages of 401(k)s break down into two different options. In a traditional 401(k), you contribute money from your paycheck before paying taxes on it. You pay the taxes on it when the money is withdrawn. In a Roth 401(k), you pay taxes when you put the money in and don’t have to pay again when the money is taken out for your use in retirement.

Employers can and often match a certain percentage of funds that employees contribute to retirement plans. It’s an important employee benefit that companies use as a carrot to attract potential hires. The tax implications of these contributions can depend on what type of 401(k) plan you have. We’ll dig into this a little deeper later.

Employers may choose to restrict their contributions so you only get access to a certain amount of the employer contribution for the first several years of your employment. At the end of the vesting period, all the money the employers contributed up to that point (and in the future) is yours. Any contributions you make are always yours to keep.

If you’re enrolled in a 401(k), there will often be an auto-saving provision that automatically takes a certain percentage out of your paycheck to be contributed to your retirement funds. This auto-enrollment amount can go up depending on your age as you get closer to retirement. You can opt out of these systematic increases, but it’s something to be aware of.

Another common feature of 401(k)s is that there are restrictions based on both the plan as well as the IRS guidelines around when your funds can be withdrawn.

How Much Should You Contribute To A 401(k)?

How much you should contribute to a 401(k) largely depends on the stage you find yourself in your career. It’s never too early to start saving and get ahead in planning for your post-career life, but it becomes much more important as you get closer to retirement age.

If you’re younger and making less money at the start of your career, it may not be reasonable to dedicate too much of your paycheck to retirement savings. That said, there are incentives to saving early. Providing your employer will match a certain percentage of your funds up to a given dollar amount, you should contribute at least enough to make sure that you’re taking full advantage of the matching program. For example, in the event that a company is willing to match 50% of your funds up to $2,500 each year, you’d actually be getting $1,250 in free retirement funds each year just by contributing up to the maximum matching amount. There’s no sense in leaving free money on the table.

At a later stage of their career while looking forward to retirement, it makes sense for a lot of people to contribute as much as they feasibly can to their retirement.

The limit for most 401(k) plans is set by the IRS is $19,000 in 2019. These limits are reevaluated each year based on cost-of-living adjustments. If you have a SIMPLE 401(k) through a small business, your contribution limit is $13,000.

If you’re 50 or older, you can contribute up to $6,000 in catch-up funds beyond the limits set up by the IRS in order to better prepare yourself for retirement. In this case, the total amount would add to be $25,000. Meanwhile a SIMPLE 401(k) from a small business the catch-up limit is $3,000, so the total contribution limit on a SIMPLE 401(k) is $16,000 if you’re over 50 years old.

Technically up to $56,000 can be contributed to a 401(k) as long as you include all of your all elective deferrals, employer matching contributions and any contributions the employer chooses to make on their own. Assuming that you’re in the catch-up period, total contributions can be $62,000.

Although these are IRS limits, each plan set up by your employer may have its own limits that may be lower than these.

It’s possible to set up a solo 401(k) if you’re self-employed, but you have to do so with the help of a plan administrator.

When Can I Withdraw Money From A 401(k)?

Different 401(k) plans may have different requirements for when you can take out money and how, but we’ll be taking you through the IRS guidelines. Absolutely make sure you review the requirements for any plan before enrolling.

Under IRS rules there’s a 10% tax penalty if you withdraw the funds in your 401(k) before the age of 59 ½. For a 401(k), you’re required to take a minimum distribution – or withdrawal – once you retire or reach age 70 ½, whichever comes later. There are situations in which you may be able to withdraw money if you experienced a hardship which caused a major strain on your finances. In this case, you pay taxes on the money you take out. But if you can show hardship, there’s no additional tax penalty.

For plans that allow it, you can also take a loan from your 401(k). You can borrow up to $50,000 or 50% of the vested funds in your 401(k), whichever is less. Commonly, the employee has to repay the loan within 5 years, following the repayment guidelines set up by the plan sponsor. Plan sponsors are allowed (but not required) to make an exception if the loan is to be used to make a down payment for the person’s primary residence.

In the event that you don’t make the loan payment on time according to your plan guidelines, it’s considered an elective distribution and is subject to a 10% tax penalty. So if you tend to do this, choose a plan wisely.

401(k) Investment Options

Once you get into a 401(k), how are the funds you invest in picked? Many 401(k) providers work closely with investment experts to help people pick the right funds for them based on their age, investment goals and appetite for risk.

Basically, there are two poles on either side of the investment spectrum and you can go anywhere in between depending on what your goals are. Aggressive investors might invest in mutual funds and stocks with a high potential for return but also a greater risk for volatility. While you can make a lot of money, there’s also a bigger risk that you lose money if the market goes down. People who are younger and have a lot of time before they retire may choose to go with a more aggressive portfolio because they’ll be able to build up their funds faster if it goes well. If they lose the money, they’ve got a lot of time to make it up.

The other side of this would be conservative investments in things like bonds with a guaranteed return. The downside here is you may not make as much money after you account for inflation. However, you don’t lose money as long as the investment is at least enough to keep up with inflation rate.

Very rarely are you going to have a portfolio that’s very aggressive or very conservative. Most people are somewhere in between. Your age plays a role in this because you’ll likely want to protect your principal against losses as you get older.

One of the things you should consider doing at least once a year is taking a look at your 401(k) and seeing how the investments are balanced with an eye toward your current financial situation, your goals and your age. Your retirement plan advisor may be able to assist you in this and even do some of it for you.

5 Pros Of A 401(k)

Now that we’ve gone over some 401(k) basics, let’s briefly summarize some of the pros.

  • A 401(k) is usually tax-deferred. An exception to this is a Roth 401(k), which we’ll discuss below.
  • As a benefit of employment, companies will often contribute a certain percentage of matching funds up to a specified amount.
  • You can set up automatic payroll deductions so retirement saving happens without you having to think much about it.
  • The amount of investment options available with any particular 401(k) plan will depend on what’s available in your employer-sponsored plan. In general, there are more options now than there have been in the past.
  • If you can prove a financial hardship, it’s possible to access your 401(k) funds without paying a tax penalty.

5 Cons Of A 401(k)

Although it can be a great option in the right situation, 401(k)s aren’t without their drawbacks.

  • Unlike traditional pensions that have a defined benefit, the money in 401(k)s is invested in mutual funds which could lose value depending on what you’re invested in and the performance of the market.
  • Because there’s a tax penalty of 10% for withdrawing funds before age 59 ½, a 401(k) isn’t considered a liquid investment. You can’t easily take your money out and put it somewhere else.
  • There are annual contribution limits beyond which an individual can’t elect to contribute more to their retirement savings.
  • There are typically management and other investment related fees associated with a 401(k).
  • Withdrawals are subject to capital gains and income tax.

Traditional 401(k) Vs. Roth 401(k)

Some employers offer a Roth 401(k) in addition to the traditional 401(k) options usually offered. In a Roth 401(k), you pay taxes on any funds you contribute at the time you make the contribution. Because you’re contributing post-tax funds, you don’t pay taxes again when you later withdraw the funds in retirement.

There are two schools of thought on this. On one hand, very rarely do we end up paying less in taxes over time. On the other hand, you’re often in a lower tax bracket once you retire because you don’t have income coming in, so you could end up paying less taxes on the money you withdraw. Some financial advisors recommend a mix of the two approaches. You could have a traditional 401(k) or IRA where the funds are tax-deferred going in while also contributing some of your money to a Roth version of these funds in order to pay taxes now and shield yourself from future tax liability.

All contributions from your employer in a Roth 401(k) are made on a pretax basis, so you’ll actually have two separate funds. One will be your funds (which have already been taxed) and one will be your employer’s funds (which are subject to tax payments upon withdrawal). However, you can do an in-plan rollover of these matching funds to Roth accounts. You just have to pay the taxes on any balance being rolled over along with any earnings on that balance when you elect to do this.

Carefully consider your options before making any investment decisions.

Is A 401(k) Right For You?

Determining whether a 401(k) is right for you may depend on a variety of factors. Here are some things to consider.

The first thing to think about is whether you have any other retirement plans available or what your other retirement options might be. Because 401(k)s and IRAs (as well as their Roth versions) have different tax benefits and downsides, it’s crucial to determine which is right for you.

It’s also important to consider your age and financial situation. If you’re young and want to save but also find you might need access to your money in the near future, investing in any kind of tax-deferred plan may not make sense because you can’t touch it without penalty until you’re 59 ½. Even if you take out a loan before retirement age, there are very specific conditions for the payback.

A final item to consider is whether your employer offers matching funds with one retirement plan option but not another. Assuming that’s the case and everything else is equal between the two plans, it’s probably worth going with the one that offers the matching funds.

If you’re interested in looking at a 401(k) or any other retirement options, you should speak with your HR department in order to determine what your employer offers, if anything. Your retirement savings are a very big deal, so it’s vital to consult with a financial advisor and even a tax professional if you have any doubts about what you should do.

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