Personal Finance - What is a 401k and how does it work?

What Is 401k?

401k Basics: What Is a 401k?

A 401k is a retirement savings plan sponsored by an employer that allows employees to save and invest a portion of their salary before taxes are taken out. The funds in a 401k account can be invested in a variety of options such as stocks, bonds, and mutual funds.

401k Contribution Limits

There are annual contribution limits set by the IRS for 401k accounts. As of 2021, the contribution limit is $19,500 for individuals under 50 years old, with a catch-up contribution of $6,500 for those 50 and older.

401k Withdrawal Rules

Withdrawals from a 401k are typically allowed penalty-free starting at age 59 ½. Early withdrawals before this age may incur penalties and taxes. Required minimum distributions (RMDs) must start by age 72.

401k Tax Benefits

Contributions to a traditional 401k are made with pre-tax dollars, reducing your taxable income in the current year. This can lead to immediate tax savings. Roth 401k contributions are made with after-tax dollars, but withdrawals in retirement are tax-free.

401k Rollover Rules

When leaving a job, you may choose to rollover your 401k funds to an IRA or to your new employer's 401k plan to avoid penalties and taxes. Direct rollovers are typically the most straightforward method.

401k vs. IRA: What's the Difference?

• 401k is an employer-sponsored plan, while an IRA is an individual retirement account that you set up on your own.
• 401k contribution limits are typically higher than IRA contribution limits.
• Employers may offer matching contributions for 401k accounts, which is not available for IRAs.

401k vs. Pension: What's the Difference?

• 401k is a defined-contribution plan where the employee contributes to their own retirement savings, while a pension is a defined-benefit plan where the employer provides a set amount of income in retirement.
• With a 401k, the investment risk is on the employee, while with a pension, the employer bears the investment risk.

401k vs. Social Security: What's the Difference?

• 401k is a personal retirement account that you contribute to during your working years, while Social Security is a government-administered program that provides income to retirees, disabled individuals, and survivors.
• 401k savings are based on your contributions and investment choices, while Social Security benefits are based on your earnings history and the age at which you claim benefits.

How Does a 401k Work?

Employer Matching Contributions

One of the key features of a 401k is employer matching contributions. This means that your employer will match a certain percentage of your contributions, up to a certain limit. This is essentially free money that helps boost your retirement savings.

Vesting Schedules

Vesting schedules determine how much of the employer's contributions you are entitled to keep if you leave the company before a certain period of time. There are different vesting schedules, such as immediate vesting or graded vesting, that dictate when you fully own your employer's contributions.

Investment Options

401k plans typically offer a range of investment options, such as mutual funds, target-date funds, and company stock. It's important to diversify your investments based on your risk tolerance and retirement goals.

Tax-Deferred Growth

One of the main benefits of a 401k is tax-deferred growth. This means that your contributions and earnings grow tax-free until you start withdrawing them in retirement, allowing your savings to compound over time.

Early Withdrawal Penalties

Withdrawing funds from your 401k before the age of 59 ½ typically incurs early withdrawal penalties, in addition to income taxes. It's important to only tap into your 401k as a last resort to avoid these penalties.

Required Minimum Distributions (RMDs)

Once you reach the age of 72, you are required to start taking minimum distributions from your 401k each year. These RMDs are calculated based on your life expectancy and account balance, and failing to take them can result in hefty penalties.

401k Loans

Some 401k plans allow you to take out a loan from your account, which must be repaid with interest. While this can be a convenient option in times of financial need, it's important to consider the long-term impact on your retirement savings.

Roth 401k vs. Traditional 401k

A Roth 401k allows you to make after-tax contributions, which means withdrawals in retirement are tax-free. In contrast, a traditional 401k involves pre-tax contributions, with withdrawals taxed as ordinary income. Choosing between the two depends on your current tax situation and future retirement goals.