Confused about how 401(k)s work? Laura explains the rules for using these tax-advantaged retirement accounts, including employer matching, contribution limits, rollovers, withdrawals, loans, and more.
Most people know they should save for retirement; however, using a 401(k) may seem too overwhelming or complicated and prevent many from getting started. When I was in my 20s, I didn’t invest in my company’s 401(k) because I wasn’t sure what would happen if I left my job. Not understanding the retirement account rules held me back, and I don’t want that to happen to you.
While 401(k)s come with critical IRS regulations you should know, they’re not as tricky to master as you might think. If you’re lucky enough to work for an employer offering a 401(k), participating can be a powerful way to build wealth for retirement.
In this guide, I’ll cover everything you need to know about 401(k)s, so you can accumulate a healthy nest egg and have a secure financial future.
What is a 401(k)?
In simple terms, a 401(k) is an employer-sponsored account for workers to save money for retirement. However, if you’re self-employed, you can have a solo 401(k).
The two main types are traditional and Roth. With a traditional 401(k), your employer (or you, if you’re self-employed with a solo 401(k)) deducts contributions from your paycheck before taxes get withheld and deposits them in your account. You defer paying tax on your deposits and investment earnings until you take 401(k) distributions in retirement.
If you don’t qualify for a Roth IRA because your income is too high, a Roth 401(k) or solo Roth 401(k) are great options because they have no income limits.
With a Roth 401(k), your employer deducts contributions from your paycheck on an after-tax basis and deposits them in your account. While you must pay tax upfront on contributions, your withdrawals of deposits and earnings in retirement are entirely tax-free.
What is 401(k) matching?
One of the most valuable benefits of participating in a 401(k) is that your employer may incentivize you by paying a match, which is free money. For instance, your company could match 100% or 50% of your contributions up to a specific limit.
Let’s say you earn $50,000 a year and get a 50% employer match up to 6% of your salary. If you save $3,000 in your retirement account, your employer will deposit $1,500. That’s an instant 50% return on your investment. Not bad, right?
Now let’s say you get the full $1,500 match year over year for the next 30 years. You’d have an extra $127,202 in your account to spend in retirement. And that’s a conservative estimate because it doesn’t account for potential increases in your wages.
Vesting prevents you from owning matching funds until you’ve been employed for a set number of years. That means if you leave your job, you could forfeit some of all of your matching funds.
There’s one catch you should know about 401(k) matches: Some employers impose a vesting schedule. Vesting prevents you from owning matching funds until you’ve been employed for a set number of years. That means if you leave your job, you could forfeit some of all of your matching funds.
However, there’s never a vesting schedule for the contributions you make from your paycheck. You always own 100% of the funds you deposit in a 401(k) and can never lose them if you change jobs or get fired.
What are the 401(k) contribution limits?
For 2022, you can contribute up to $20,500 to your 401(k), or up to $27,000 if you’re over age 50. These limits have been increased by $1,000 from 2021.
Also, note that the annual contribution limit doesn’t include any employer matching. So, if you contribute $20,500 and your employer adds $2,500, it’s icing on the cake!
Can you take 401(k) withdrawals?
Since the purpose of a 401(k) is to invest for retirement, there are rules against taking withdrawals before age 59½. If you tap into your 401(k) early, you typically must pay income tax plus a 10% early withdrawal penalty.
However, there are penalty exceptions. For instance, the Rule of 55 says that you can take distributions penalty-free if you leave your job after age 55. That’s excellent news if you want to retire early. However, you still must pay income tax on withdrawals that weren’t previously taxed.
Additionally, you can skip the early withdrawal penalty for qualified hardships, such as becoming disabled, paying for education expenses, or avoiding foreclosure on your primary residence.
Once you reach age 72, you must begin taking required minimum distributions (RMDs) from a 401(k). The amount depends on the balance in your account and your life expectancy defined by IRS tables. RMDs that weren't previously taxed get included in your taxable income.
Can you take 401(k) loans?
Another option to withdraw from your 401(k) is a loan—if your plan permits it. While it can be tempting to borrow from yourself, be sure you understand the following:
- You typically must repay a 401(k) loan within five years.
- Your 401(k) loan payments get deducted from your paychecks.
- You must repay interest on 401(k) loans to make up for lost investment time.
- You can’t take a 401(k) loan that exceeds $50,000 or 50% of your vested account balance, whichever is less.
- You may get prohibited from making new contributions while repaying a 401(k) loan, leaving you unable to enjoy investing growth and employer matching.
What happens to a 401(k) if you leave a job?
If you leave your company, you can no longer make any new contributions to your old employer’s retirement plan. However, it’s easy to take your vested 401(k) balance with you.
Here are five options you have for your 401(k) when leaving an employer:
- Cash it out.
- Leave it with your ex-employer.
- Roll it over to an IRA.
- Roll it over to a 401(k) with a new employer.
- Roll it over to an account for the self-employed.
Most people choose to do an IRA rollover with their old 401(k) to have more control over their investment options and fees. But if you have a new job with a retirement plan or become self-employed, moving funds to a new 401(k) or solo 401(k) are also excellent options.
The worst option for an old 401(k) is cashing out because it’s an early withdrawal if you’re younger than 59½. You’d have to pay income tax plus the hefty 10% penalty, leaving you with significantly less money.
How to start investing in your 401(k)?
If your employer offers a 401(k), you may already be enrolled and not know it! Many companies auto-enroll new employees to encourage participation. You can review your last paycheck or contact your benefits administrator for more information.
If you already have a 401(k), log on to your online portal to adjust your contribution amount, choose investments, and see your employer match. Most plans offer a diversified investment menu that includes mutual funds, exchange-traded funds, and money market funds.
Target date funds are a mutual fund type that’s become popular in 401(k)s. They allow you to select a fund based on the date you expect to retire.
Target date funds are a mutual fund type that’s become popular in 401(k)s. They allow you to select a fund based on the date you expect to retire. Then the fund automatically adjusts its underlying investments to be more conservative as the date approaches.
If you don’t understand your 401(k) investment choices or need help selecting appropriate funds for your financial objectives, speak with a financial advisor. Many 401(k)s offer free or low-cost guidance for plan participants.
Some 401(k) plans include auto-escalation, which automatically increases your contribution rate over time (such as 1% per year) until you hit a limit. That’s an excellent feature for slowly building your savings rate over time.
What are the advantages of a 401(k)?
Here are several pros for using a 401(k) to invest for retirement:
- Many employers offer a 401(k) matching program that incentivizes you to save by making free contributions on your behalf.
- You reduce your tax bill by making traditional 401(k) contributions.
- You get tax-free withdrawal in retirement if you have a Roth 401(k).
- You own your vested 401(k) funds and can take them with you when you leave a job.
What are the disadvantages of 401(k)s?
Here are a few cons for 401(k)s:
- Not all employers offer a 401(k) retirement plan.
- You typically can’t tap a 401(k) before age 59½ without paying an early withdrawal penalty.
- You may pay higher investment fees compared to other types of retirement accounts, such as an IRA.
- You may have fewer investment options than with an IRA (however, some might see that as a benefit).
Use a Compound Interest Calculator to see how much your 401(k) could grow!
What questions do you have about 401(k)s and other retirement accounts? Let me know by leaving me a voicemail at 302-364-0308. Want to keep in touch? Follow me on Instagram or sign up for my weekly newsletter at LauraDAdams.com.