401(k)s are some of the most valuable, yet underutilized retirement plans available for the working American. Employees are not required to invest in a 401(k) plan, but the tax and vesting benefits are compelling. Herein we’ll review exactly what a 401(k) is, the benefits of such a plan, how a 401(k) works, and the differences between traditional and Roth options.
What is a 401k?
A 401(k) is a retirement savings plan that is sponsored by your employer. It helps you save for retirement by investing money before taxes, and oftentimes a percentage of this investment is also matched by your employer.
401(k)s were created in the 1980s to supplement pensions. As pensions were slowly phased out, employers adopted 401(k)s in their place. The employees themselves have control over how these accounts are invested, and can hold their investments in money market accounts, stocks, mutual funds, or bonds.
A 401(k) is different from a traditional savings account in that it has unique features and restrictions:
- Vesting – Vesting is the process by which your employer matches a portion of your contribution. Oftentimes an employer vests this money over a number of years. This rewards workers for longevity, as employees who quit before their employer’s contributions are fully vested lose that money at the time of their departure. It’s always beneficial to ask a potential employer about their 401(k) vestment policy.
- Withdrawals – Additionally, there are penalties for early withdrawal. Most 401(k) plans require that the investor meet a minimum age requirement of 59½ before they can withdraw money, lest they incur a penalty of 10%. This helps encourage employees to save until they reach retirement age.
- Contribution Limitations – The IRS limits 401(k) contributions to $18,000 per year, although this amount is subject to increase each year to keep up with cost-of-living adjustments. In the case that you are contributing at an age of 50 years or older, you may add additional contributions of up to $6,000 per year. These are considered catch-up contributions, and are offered to help you reach your retirement goals.
How Does a 401(k) Work?
Contributions are automatically deducted from each paycheck, and a certain percentage of that contribution is matched by the employer (commonly 3%). Investing at least up to the company match is encouraged, and assures the employee that they are not leaving money on the table. All contributions are invested based on the employee’s investment preferences.
What Is the Difference between a Traditional and Roth 401k?
There are two types of 401(k)s: traditional and Roth. There are stark differences between these two types of 401(k)s, and it is up to the employee to decide whether to choose one, the other, or both. A commonly circulated suggestion is to invest in both and “hedge your bets”. Because it is difficult to predict the future, investing in both plans can help even out the risk of waiting until retirement to find out whether it was best to withdrawal funds at your earlier employment tax rate, or at your retirement tax rate.
- Money is contributed before taxes are taken out. This lowers employee’s taxable income for the year by the amount contributed to the plan.
- Income taxes and taxes on earnings are collected upon withdrawal.
- Money is not accessible without a 10% penalty before the age of 59½ (or at age 55 if the employee retires, quits, or is fired from employment).
- Money is contributed after taxes are collected.
- No taxes are paid upon withdrawal.
- Money is accessible as long as the employee has held the account for 5 years.
The decision between a Roth and a Traditional 401(k) and the way contributions are invested is a personal choice, but a few standard practices exist. When it comes to investments, there are also many target-date funds available that help employees manage their funds according to these standards.
These funds automatically rebalance the employee’s account to reduce risk as the retirement date draws near, adjusting from stock-heavy investments to bond-heavy investments over time.