How does a 401(k) plan work?
A 401(k) plan is one of the most common retirement accounts available to employees. And while there’s a lot of intimidating language surrounding them, 401(k) plans operate in pretty simple ways. In fact, they’re so simple that we’re going to be able to explain it to you in about a thousand words. Here we go.
You know that if you don’t want to work forever, it’s important to save some of your money so you can eventually provide for yourself and your family once you stop working. A 401(k) plan is a vehicle that allows you, as an employee of a specific company, to save money for your eventual retirement and deduct the money you put into that plan from your taxes each year in many cases. So let’s say that you save $5,000 in your 401(k) plan this year. You can now deduct $5,000 from the amount of income you earned this year when you file your taxes, which means you don’t have to pay tax on that $5,000. So the purpose of the 401(k) plan is that it gives you a place to save money for retirement in a tax-efficient way. 401(k) plans do have limits as to how much you can contribute in tax-deferred fashion. That limit stands at $19,500 for 2019, though employees age 50 and older can contribute an extra $6,000 on top of that, for a total of $25,500 per year.
401(k) plans are typically funded through something called a payroll deduction. This means that you tell your employer how much of your income for a specific pay period you want going into the plan, and the money is automatically pulled out of your paycheck for that period and sent into the plan. Its automatic nature makes it really easy to save since you don’t have to think about it every week or every month. If you really want to get technical, you don’t have to remember to do anything after you enroll in your company’s 401(k) plan unless you need to make changes. Most employers also let you adjust your contributions if you want or need to. This means that if you get a raise one year, you can go to your employer and ask to have more money put into your 401(k) if you want to save more. Or, if you have some college tuition bills coming up this fall, you can go to your employer and tell them you want to save less since you need the cash flow. Ultimately, the money must come from payroll deductions.
Some companies also offer what is called a 401(k) match.
The premise is pretty straightforward – in addition to your contributions, the company offers to make contributions on your behalf as well. Different companies set up their matches differently, so make sure you understand the specifics of your company plan. Some companies may match contributions up to the first 3% of your income, some companies may match up to 5% but require you to contribute 10% to get the maximum match, some companies may not offer a match at all, and there are a ton of different permutations in between the basic ones laid out here. But the concept of a 401(k) match is something you need to be familiar with, because it’s money that your employer wants to pay you. You just have to make sure you are doing what you need to do in order to qualify for their contribution. If you don’t take advantage of 401(k) matching, you are leaving money on the table that otherwise would have been paid to you.
Now, while 401(k) plans do give you a tax deduction in the year you make a contribution, that money does eventually have to get taxed. This is what is called tax-deferral. In the case of a 401(k) plan, the money is taxed as ordinary income once you withdraw it from the account. But there are some stipulations. If you pull money out prior to age 59.5 and don’t meet one of the reasons for getting a waiver, you will be assessed a 10% tax penalty in addition to the taxes you already had to pay.
As far as what your 401(k) contributions are going to go into, most plans offer between 10 and 20 different investment options. You can choose one of them or a combination of a few, or you can place a little bit of money into each bucket. What you should invest in is something that is going to be specific to you, your risk tolerance, when you need access to the funds, and other factors that affect what you should be investing in. But most plans offer a range of different options, from more stable options like bonds and other fixed income investments, as well as equities that typically include selections from both domestic and international markets. In addition, 401(k) plans must now disclose any and all expenses associated with those investments, so you should have a good idea today of the cost of your investments as well.
For most employees with access to a 401(k) plan, it provides you with a simple, automatic way to make tax-deferred retirement contributions on a regular basis. It allows for higher contribution limits than a Roth IRA or Traditional IRA, and is typically the type of account that forms the basis for most people’s retirement savings, largely because of its ease of use, high contribution limits, and automatic nature of the savings that you dictate.