401(k)

The 401(k) retirement plan was created in 1978 and has grown to be the most popular type of employer-sponsored retirement plan in America. In many cases, a 401(k) is many American’s retirement for when they hit retirement age. Not many have investments outside of their 401(k).

A 401(k) is fairly flexible and your employer match makes it all the better to make sure you’re taking advantage of having a 401(k).

Key Facts

A 401(k) plan is a retirement savings account that allows an employee to divert a portion of their salary into long-term investments before taxes are taken out of their check. The employer may also match the employee’s contribution up to a limit. This limit varies by employer but typically it’s 5% or less.

A 401(k) is a qualified retirement plan which means it is eligible for special tax benefits under the IRS. The qualified plans come in two versions: defined-contribution or defined-benefit. A 401(k) is considered a defined-contribution plan.

A defined-contribution plan is a plan where the balance is determined by the contributions made to the account and the overall performance of the investments. The employee MUST make contributions to the 401(k) plan. The employer does not always have to match but most do if they offer a 401(k). The investment earnings in a traditional 401(k) are not taxes until you withdraw your money, typically after you’ve fully retired. After you retire your account balance is placed entirely in your hands to do what you see fit.

The way an employer contributes can be different depending on your company. They may match 100% of your contribution up to a certain percentage or 50% of your contribution up to a certain percentage. The most common form is to match 100% up to 3% of the employee’s salary. So if you make $100,000 per year you can expect them to contribute $3,000 to your 401(k), as long as you’ve contributed at least $3,000.

There are a few key benefits to a 401(k) with one of the bigger ones already mentioned.

The benefits of a 401(k) are:

As we’ve shared with you, the best perk of a 401(k) plan is that your employer is investing into your retirement for you. They are helping you by basically giving you free money to use when you retire.

Not only is the employer match a major benefit, but you do get a few tax breaks. When you contribute to your 401(k) it’s all pre-tax income and therefore not touched by the government. Not only is it pre-tax but when you retire it isn’t counted as income so you are not tied to an income tax on your money. This won’t bump you into a new tax bracket causing you to pay more into the government. Finally, the savings will grow tax deferred which means your gains will grow tax free unlike other investments. Other investments are taxed periodically on any gains or dividends paid out.

If you happen to get into some financial hardship and are not able to manage your debt then you can feel good knowing your 401(k) cannot be touched by creditors. They cannot make a claim against you to get money out of your 401(k). It is protected by the Employee Retirement Income Security Act of 1974.

The max you can contribute to your 401(k) is $19,500 for 2020. It changes yearly and in 2019 the max contribution was $19,000.

If you’re 50 and older you are eligible to make “catch-up” contributions. You can make extra payments into your 401(k) to help grow it faster. The max for 2020 is $6,500 for catch-up contributions.

In total, between the employee and employer, the maximum join contribution to a 401(k) for 2020 is $57,000.

If you happen to switch jobs while you have an active 401(k) then you’re in luck. A 401(k) is one of the most flexible retirement options out there.

When you switch jobs you have two options: rollover or cash-out.

In nearly every situation you should rollover your 401(k) into your new employers plan. A 401(k) rollover will allow you to transfer your funds from your current employer to an individual retirement account (IRA) or to a 401(k) sponsored by your new employer.

If you cash out your 401(k) you can face steep penalties, income tax fees and even a 10% withholding fee to process everything. Depending on how much is in there, you could lose up to 20-25% of your 401(k).

An IRA is an individual retirement account. An IRA can be opened by anyone and doesn’t need an employer to do so. If you’re an independent contractor or if you want to save even more for retirement outside of your 401(k), you should look at an IRA account.

The most common type of IRA account is a Roth IRA. The primary difference in how IRAs work is how they are handled with taxes and the IRS. You can learn more about IRAs and how they work with our guide to IRAs.

A mutual fund can be tricky with taxes. The biggest thing people forget is that any capital gains are required to be distributed to shareholders. If the fund had a good year then you may end up seeing quite a bit of income your way. This can either offset some losses or potentially put you in a new tax bracket and cause you to owe more taxes.

If the capital gains are short-term then you only pay income tax on the distribution. If it was a long-term capital gain then you’ll pay a lower capital gains rate.

If the fund pays a dividend then you’ll have to claim it and pay taxes on them. A dividend is treated as ordinary income and will be taxed as such.

The best way to avoid taxes on the distribution is to put this income into a tax-deferred account, such as a traditional IRA or a 401(k). This is especially good if you don’t plan on using the money any time soon.

The key difference between an IRA account and a 401(k) is that your 401(k) is tied to your employer and an IRA is completely set up and managed by you. A traditional IRA is very similar to a 401(k) in how they are set up and managed. A withdrawal from a Roth IRA is tax-free since all contributions are made after you’ve paid taxes on your money.

An early withdrawal can incur income taxes and a 10% tax penalty if you have taken the money out before you hit 59.5 years old. In order to take money out of your 401(k) you need to have a “triggering event”. A triggering event is typically a life or career altering event.

The most common 401(k) triggering events:

There are some cases where special rules are made regarding withdrawal. A majority of the time it’s to remove the 10% fee added onto the income taxes you pay.

The CARES Act allows anyone affected by the coronavirus situation, whether you got the virus or not, a hardship distribution up to $100,000 without incurring the 10% penalty for being under 59.5 years old. The account owners will have three years to pay any taxes owed on withdrawals. It is up to the plan sponsor and the employer to approve the hardship.

The ultimate goal is to put around 10-15% of your yearly income towards your retirement, even if it’s not in a 401(k). Generally the amount you should be putting into your 401(k) is decided upon how much your company is willing to match.

At a minimum, you should be putting in enough to get the max contribution from your employer and no less. If you’ve already matched what your employer will give then you should move the leftover funds into another retirement account, like a Roth IRA.

If you withdraw your 401(k) funds before you’re 59.5 years old then you will incur fees. There are two main fees you’ll have to pay when you withdraw.

The two penalties for cashing out a 401(k) are:

If you have a smaller amount in your 401(k) and you’re in financial hardship, it may make sense to withdraw early and incur the small fees to get yourself out of a rut. However, if you’ve been saving for years these penalties can be pretty massive.

For example, let’s assume you have a 401(k) with $250,000 saved up and you want to take it out early. You’re immediately going to be hit by the 10% early withdrawal fee which will take $25,000 from you. You’re now at $225,000 left of your earned $250,000. The next thing to factor in is taxes and those aren’t cheap, depending on how much money is in your 401(k). Since we started at $250,000 it puts us in the 33% tax bracket (if you’re a single filer). That 33% income tax on our total, after the 10% fee, will put us around $160,000. To wrap this up, the early withdrawal just cost you nearly $100,000 of your retirement.