401k is synonymous with a retirement savings plan, and if you want to understand what a 401k is and how setting one up works, this is the place.
The number (and one letter) 401k is synonymous with a retirement savings plan, but how many of us actually know all the rules around 401k accounts? Or where that number comes from?
To answer the most basic question right off the bat, the number 401 (and yes, that extra little letter) come from the internal revenue code that allows employers to help employees develop a retirement saving option to be taken directly out of their earnings before income taxes are deducted.
If you are seeking investment advice, you should definitely contact a financial advisor, or ask your local community bank or credit union for personal financial advice. If you want to understand what a 401k is and how setting one up works, this is the place.
We'll walk you through all the finer details, but we also know you're busy, so we've whipped up this handy table of contents for you. Feel free to self-serve some of the most frequently asked questions about 401k plans, or binge it all, top to bottom.
Now, onto the good stuff:
What is a 401k?
A 401k is an employer-sponsored retirement account. It allows employees to dedicate a percentage of their pre-tax salary to a retirement account. These funds are invested in various vehicles like stocks, bonds, mutual funds, and cash.
Depending on your benefits with your company, your 401k may include an employer contribution, which often is paid as matching funds — your employer will match what you contribute up to a set amount or percentage.
How does a 401k work?
A 401k plan — technically a 401(k) — is a benefit commonly offered by employers to ensure employees have dedicated retirement funds. A set percentage the employee chooses is automatically taken out of each paycheck and invested in a 401k account.
The account is managed by an investment company of the employer's choosing. The 401k contributions are invested in stocks, bonds, and mutual funds, which the employee can select themselves.
Depending on the plan's details, the money invested may be tax-free, and matching contributions may be made by the employer. If either of those benefits is included in your 401k plan, financial experts recommend contributing the maximum amount each year or as close to it as you can manage.
What are the benefits of a 401k?
401k tax benefits are hard to dispute, as they can offer workers much financial security, including:
Shelter from creditors
In fact, let's dig into 401k benefits a little deeper.
401k employer match
Do you like free money? Good, now that we've gotten that out of the way: A company-matched 401k is basically that. Many employers offer to match employee contributions, either dollar for dollar or 50 cents to the dollar, up to a set limit. Employer contributions are in addition to, not part of your salary, but they may be part of an employee's overall compensation package.
For example, say you make $100,000 a year, and your employer offers a 401k matching of 50% up to the first 6% you elect to contribute. If you contribute 6% of your annual earnings ($6,000), your employer would contribute an additional 50% of that amount. So, 3,000 free dollars.
It's up to your employer to decide what percentage they will match, but many companies do offer a dollar-for-dollar match.
401k tax breaks
The tax benefits of 401(k)s are like the triple-crown of finances. First, contributions are pre-tax. You don't pay taxes on the money until you withdraw it when you retire. (At the earliest, this is age 59½.)
Second, your 401k contributions are not counted as income, which could put you in a lower tax bracket. The result: your tax bill will be smaller for your having squirreled away money for your later years.
Third, your savings grow tax-deferred. In a regular investment account, your net gains and dividends would be taxed. But in a 401k plan, your money grows tax-free as long as it stays in the plan. This allows your earnings to compound — which is just a fancy way of saying your earnings will earn earnings.
401k shelter from creditors
If your finances take a turn for the worse, you won't have to worry about creditors coming for your 401k. Your qualified retirement plan is protected by the Employee Retirement Income Security Act of 1974 (ERISA) from claims by judgment creditors.
What is the maximum 401k contribution for 2022?
That depends on your employer's plan. The maximum the IRS allows for 2022 rose by $1,000 from last year. Currently, the cap sits at $20,500, but your employer may cap the amount below that. For people over 50, the maximum increases to help them "catch up" before their retirement. They can contribute an additional $6,500 a year.
What happens to my 401k if I change jobs?
You have a couple of options, but the one most people would recommend is a 401k rollover. A 401k rollover is when you transfer your funds from your old 401k from your previous employer to an individual retirement account (IRA) or to a new 401k plan set up with your new employer.
When you roll over the funds — all of the funds — to a qualifying IRA or 401k account, you do not have to pay taxes on the transfer. You will receive a 1099 (that's the tax form number) stating that the funds changed accounts. Again, this is not taxable income. The tax form is for information purposes and includes a code that identifies it to the IRS as non-taxable.
A much less popular option is to cash out your 401k. This comes with massive penalties, income tax, and an additional 10% withholding fee. Keep reading for details on those penalties.
What is an IRA?
While there are several benefits to 401(k)s, they're not the only retirement plan in the game. An IRA, or individual retirement account, is similar in structure but not tied to your place of employment.
Whereas a 401k can only be offered through an employer, an IRA account can be opened up by an individual whether they're associated with an employer or not. That means they're the best option for independent contractors without an employer or anyone who wants to do some extra retirement planning on top of their 401k.
What is a Roth IRA?
A Roth IRA is a type of individual retirement account similar to traditional IRAs in many ways but with some significant differences. One of the main differences is in the tax breaks. With a traditional IRA, the money you put in isn't taxed; with a Roth IRA, the money you take out (once you've retired) isn't taxed. Roth IRAs also have no requirements on when the money must be taken out, so they can be a good tool to pass along wealth to your beneficiaries if you find you don't need the money in retirement.
What are the rules for a Roth IRA?
Roth IRAs are only available to people making less than $129,000 a year as an individual or $204,000 for married couples. The IRS has contribution limits of $6,000 a year, or $7,000 for those over 50.
Unlike 401ks and traditional IRAs, there's no penalty for withdrawing part of your Roth IRA contribution early.
What are the traditional IRA contribution limits?
A traditional IRA has the same contribution limits as a Roth IRA: $6,000 for most people, $7,000 for anyone over 50.
How is an IRA different from 401k?
401k accounts are associated with your employment, as contributions are taken from your wages before taxes. A traditional IRA is similar to a 401k in that contributions aren't taxed (they are deductible), but the key difference is that they are independent of your employer.
A Roth IRA is also independent, but contributions are made after taxes. Withdrawals from your Roth IRA are tax-free, which makes them a smart choice if you think taxes will be higher in the future.
When can you withdraw from your 401k without a penalty?
If you want to start withdrawing the money without penalties, 59½ is the current age when you can take money out of your 401k. However, the money you take out is still taxed as income. At the age of 72, you will be forced by the IRS to start taking distributions from your retirement accounts.
If you're more than six months away from your 60th birthday, be sure to read the below section about penalties for early withdrawals from your 401k
How much should I be putting into my 401k?
A piece of general advice from experts is to put all of those funds into your 401k up until your employer's matching contribution amount.
Where to invest after getting all the benefits of your employer’s matching funds depends on your individual financial plan. Your community bank or credit union may be the best place to turn for real-life recommendations to meet your long-term goals — they should already have a good picture of your finances.
Tip: You should aim for a retirement income of roughly 80% of your current salary.
What are the penalties if I cash out my 401k early?
If you withdraw funds from your 401k before the age of 55½, you will pay a 10% early withdrawal penalty on the amount you withdraw, plus federal and state taxes on all the funds. This adds up. Let's say you have $250,000 in your 401k, and you want to take it out early. After penalties, you will have around $180,000. A loss of $70,000.
You will be responsible for federal taxes on that withdrawal. You may pay at the time of the withdrawal or when you file your taxes for that year.
Are there other kinds of retirement accounts?
401k and IRAs are the two main retirement accounts. There are a couple of other types available to small business owners or the self-employed: SEP IRAs and Simple IRAs.
SEP IRAs are designed for those who are self-employed and only need to invest for themselves.
Simple IRAs are ideal for small business owners with a handful of employees who want to set up retirement accounts for those employees.
What happens when I retire?
That's an entirely new list of questions to be answered. You will be required to take minimum distributions from your 401k each year after you reach the age of 72. These required minimum distributions will be based on the total amount of the account and the life expectancy of your age.
For now, you are focused on putting money into whichever investment options are best for you. Get busy saving!