The 401(k) is the most common type of workplace retirement plan. It provides employees a tax break when they save money and withdraw it in retirement.
Some 401(k) plans also offer employer matching contributions free money to help speed up retirement savings. But how exactly does a 401(k) work?
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Taxes
A 401(k) is a retirement savings plan that allows employees to defer part of their salary on a pre-tax basis, with matching contributions sometimes offered by employers. The name comes from the tax code section establishing this type of plan. Some plans may have an underlying profit-sharing, stock bonus, or pre-ERISA money purchase pension arrangement; other options include the safe harbor 401(k) and the Simplified Employee Pension Plan (SEP).
One of the key advantages of a traditional 401(k) retirement plan is that it helps lower taxable income for employees while encouraging them to save for retirement. Because the contribution is made before taxes are removed from paychecks, it reduces taxable income and allows the funds to compound more quickly. Similarly, when the money is withdrawn from the plan in retirement, it is considered ordinary income and taxed at that time.
Traditional 401(k) participants can avoid the withdrawal tax hit by moving their assets to another account within 60 days. This way, the government doesn’t consider it a distribution. If a participant withdraws their money directly, however, they will be required to pay applicable taxes and, if they are under 59 1/2, an additional 10% early distribution tax. Those needing to access their funds can also consider taking out a loan.
Investments
A retirement plan is one of your most important financial decisions. However, many people need help prioritizing retirement savings amidst competing financial priorities. For example, student debt and competitive job markets can easily crowd out the time and energy needed to save for a future that may not arrive for several years.
Fortunately, many employers offer 401(k) plans to help their employees save for retirement. Typically, these are tax-advantaged investment accounts where employees can contribute a portion of their salaries. In addition to providing a tax break, these accounts allow participants to choose their investments. Most 401(k)s offer between eight and 12 investment options, most of which are mutual funds. The index fund is the most popular type of mutual fund in a 401(k), which invests in a broad range of stocks. Choosing mutual funds with low fees can significantly boost your returns.
Inflation and interest rates greatly impact 401(k) investments. Rising rates can hurt stock performance while falling rates can boost the yield on short-term bond funds and cash alternatives. Ideally, it would help to have a mix of short- and long-term bonds in your portfolio.
While market declines can be scary, you must remember that they are only temporary. If you keep a well-diversified portfolio and continue to save through both bull and bear markets, you should be able to ride out the occasional rough patches.
Matching Contributions
Employers may offer a matching contribution program, meaning they will put money into the account for every dollar you contribute up to a certain limit. This is free money, as your employer’s contributions are pre-tax and don’t count towards the IRS limits on how much you can contribute per year.
This matching type is a common incentive employers offer to encourage employees to invest in their retirement plans. However, the amount of match money an employee receives will depend on several factors, including the size of their paycheck, investment choices within the plan, and the time until retirement.
Some companies will provide a dollar-for-dollar match on employee contributions, while others will only make partial matches up to a certain percentage of the employee’s base pay. For example, an employer might offer to match 50% of any contribution up to 6% of the employee’s base pay.
If the company faces financial difficulties, it might stop matching contributions for a while. This allows employees to shore up their finances and ensure they can continue contributing to their retirement accounts even during tough times. Employees should assess their situation carefully to see if it is possible to keep investing. If not, they might consider looking for a new job with better retirement savings plans.
Loans
Many retirement plans allow participants to borrow against their vested accounts, subject to plan limits. Borrowing from a 401(k) is easy and convenient, with no paperwork or credit checks required. In addition, 401(k) loan repayments are typically allocated directly back into your account’s investments. However, if you use your 401(k) to meet serious liquidity needs, it is important to remember that a loan from this account will cost you investment earnings, at least for the amount you miss out on while repaying the loan.
It is also important to note that you can only make additional contributions to the plan if you have an outstanding loan. This means you may miss out on employer-matching contributions and other valuable investment opportunities during this period. In addition, you will not earn investment interest on the money you borrow from your 401(k) because loan repayments are made with after-tax dollars.
Although some select financial counselors endorse 401(k) loans under certain conditions, most advisors advise against them. Dividing into your retirement funds to address short-term liquidity needs goes against almost every time-tested principle of long-term investing. However, suppose you need to borrow from your 401(k). In that case, it can be a relatively simple and inexpensive process with minimal impact on your retirement savings progress, especially if you pay back the loan on schedule.