401(k) Plan

What is a 401(k)?

A 401(k) is a retirement account sponsored by an employer. 401(k)s lets workers save and invest a piece of their paycheck before taxes are taken. These contributions and any earnings from the 401(k) investments are not taxed until they are withdrawn.

How 401(k) Plans Work

The 401 (k) of the IRS Internal Revenue Code authorized the use of a defined contribution plan that allows the employee to make pre-tax contributions to a retirement savings plan.

A defined contribution plan is a retirement plan in which the employer, employee, or both make regular contributions. With a 401(k), you don’t pay federal or state income taxes on your savings or investment earnings until you withdraw the money at retirement.

With 401(k) plans, you decide how much to save, up to the IRS’s contribution limit, and choose the investments based on your plan. Your employer contracts a retirement plan administrator and manages the 401(k) plan participants. When you leave your job, you still maintain ownership over your account.

What are the benefits of 401(k)s?

Tax-advantaged

These plans have tax-advantaged benefits and can support your goal of achieving financial independence. Most 401(k)s are pre-tax contributions that affect your taxable income. You don’t pay taxes until you withdraw the money at retirement, with the earliest being 59.5 years old. Since you contribute pre-tax dollars, you reduce your gross taxable income.

Extra money

Many employers also agree to match your 401(k) contributions. Depending on your employer, they may match dollar-for-dollar or a percentage of your contributions.

For example, an employer match may offer 50 cents for every dollar you contribute, up to a certain percentage of your salary (perhaps 3% to 6%). So, if in a calendar year you contribute $5,000, your company would put in $2,500. Think of this matching contribution as money that’s yours. You want to contribute at least to the match so you don’t leave money on the table.

Protected

In the event your finances sour, your qualified retirement plan is protected from creditors or judgments. The Employee Retirement Income Security Act of 1974 (ERISA) protects your plan from claims.

How to contribute to a 401(k) Plan

You must work for a company that offers an employer-sponsored retirement savings plan. Many employers offer a 401(k) Plan as part of their employee benefits package. You can enroll with your company’s 401(k) Plan when you start a new job. Learn more about enrolling in a 401(k).

401(k) Contribution Limits

The maximum pre-tax contribution dollar amount is $23,000 per year as of 2024, set by law and adjusted for inflation annually. Check IRS.gov for changes to these limits.

Calculating how much to contribute to a 401(k)

Start by making sure you are contributing at least the percentage amount that your company is matching. For example, if the employer match is 5%, make sure you contribute at least 5%. Most 401(k) plans have retirement goals based on the years before retirement using target-date funds.

It’s an easy way of gauging how much you need to invest and at what risk level. Some financial experts recommend that 20% of your income go into long-term retirement savings–a combination of a 401k, IRA, or other investments that are expressly set aside for retirement.

You could start at 5% or 10% and increase the contribution by one percent yearly. Are you worried that increasing your contribution will reduce your take-home pay too much? Use the IRS Take Home Pay Calculator to see how increasing your contribution will impact your take-home pay.

Vesting of Matching Contributions

Any money you contribute from your paycheck is always 100% yours. However, company matching funds usually vest over time – typically 25% or 33% a year or all at once after three or four years. Once fully vested, you can take the entire balance with you when you leave your employer.

Transferring your 401(k) plan after changing jobs

Through a 401(k) rollover, you can transfer your 401(k) plan from your former employer into an Individual Retirement Account (IRA) offered by brokerage services. The most straightforward 401(k) transfer is through a trustee-to-trustee to eliminate potential tax consequences for early withdrawal.

Request the distribution forms from your former employer. Ensure you open your new IRA before the transfer to provide the account information on the required forms. There are no penalties with a trustee-to-trustee transfer, but if you allow your former employer to send the funds directly to you and not to your new IRA, they will be required to deduct and remit 20% of the total to the IRS.

  1. Request the distribution forms from your former employer.
  2. Ensure you open your new IRA before the transfer to provide the account information on the required forms. There are no penalties with a trustee-to-trustee transfer, but if you allow your former employer to send the funds directly to you and not to your new IRA, they will be required to deduct and remit 20% of the total to the IRS.

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401(k) Early Withdrawals

Need to access your money in a 401(k)? You may face an early withdrawal penalty if you are younger than 59½ years old.

There are exceptions to avoid the 10% early withdrawal tax penalty if you aren’t yet age 59 ½. For example, you can request a hardship withdrawal that includes medical or funeral expenses, postsecondary tuition, and certain costs related to your primary residences, such as buying, damage repair, or eviction prevention.

Remember that hardship distributions of pre-tax contributions and earnings are subject to tax and may incur the 10% early withdrawal penalty. You want to avoid withdrawing money from your 401(k) before retirement.

Catch-up Contributions

The maximum employee contribution is $23,000 (in 2024). For those 50 years or older, you can contribute an additional $7,500 as a catch-up contribution, raising your total contribution limit to $30,500.

Difference Between 401(k), a 403(b), and a 457(b)

The 403(b) and the 457(b) are tax-deferred plans. Generally, a 403(b) plan is available to employees of educational institutions, and a 457(b) is available to government employees. The IRS Internal Revenue Code allows educators to use the 403(b) and 457(b) plans to prepare for retirement.