A Beginners Guide To A 401K Plan

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You’re here because you just accepted a job that offers you a 401k plan and have no idea if you should invest in it.

Or maybe you’ve been working a job and haven’t put much thought into investing in your plan until now.

Whatever the case, here is a beginner’s guide to a 401k plan.

You’ll learn things like:

  • Is a 401k plan worth it?
  • How does it work?
  • What are the benefits and drawbacks?

There are a lot of questions about this type of retirement account.

The truth it is, investing in it is one of the best things you can do for your future self.

In this post, I walk you through everything you need to know about 401k plans.

A Beginners Guide To A 401K Plan

What Is A 401k Plan?

beginners guide to a 401k plan

A 401k is a type of retirement plan that allows you to make pre-tax contributions from your paycheck to save for retirement.

The most common type is a traditional 401k but Roth 401k plans have grown in popularity in recent years.

Later in this post, I’ll walk you through the pros and cons of both of these plan types.

How A 401k Plan Works

A 401k plan works by having you make pretax contributions from your salary.

The contributions you make are taken out of each of your paychecks during the year and invested in your 401k.

For example, say you earn $50,000 and you want to invest $5,000 in your plan.

If you get paid bi-weekly, or 26 times a year, you will invest $192.31 from each paycheck.

This will lower the amount of your paycheck since you are funding the account from your earnings.

It will also lower the amount of income tax you pay as well.

Most companies allow you to contribute a flat dollar amount or by percentage.

In this case, you could say you want to save 5% from each paycheck.

401(k) Retirement Plan Contribution Limits

As great as a 401k plan is, there are limits to how much money you can contribute.

For 2022, you can contribute up to $20,500 in elective employee salary deferrals.

If you are over age 50, you can contribute an additional $6,500 as a catch-up contribution.

Employer Matching

Employer contributions, also called 401k matching, is when your employer puts money into your account for you.

An employer may offer to match, while others do not.

Many people refer to a match as free money since it is in addition to your normal salary.

For example, if your employer contributes $1,000 into your 401k, this is not part of your salary.

It is cash your employer is giving you to save for retirement.

The confusing part of this is the way employer matches work.

Most times it is a percentage match up to a maximum dollar amount.

You might see it as a 50% match up to 6% of pay.

What this means is your employer will match every dollar you contribute with $0.50 up to a maximum of 6%.

Here is an example.

Let’s say you earn $40,000 and you contribute $2,000 annually.

Your employer will put in an additional $1,000 into your 401k plan.

If you still make $40,000 but you contribute $6,000 annually, your employer will only match $1,200.

This is because 6% of your pay is $2,400 and 50% of this is $1,200.

I know this can be confusing.

The important thing to remember is that if your employer offers a 401k match, you should take advantage of it.

As I’ve said, it is basically free money to you.

401k Investment Options

retirement savings success

There are two investment options for your 401k plan.

Your investments can either be in mutual funds or company stock.

Mutual funds are a collection of stocks and bonds that are professionally managed.

These are the most common investment vehicle since they are low cost and diversify your risk.

Some companies will allow you to invest in company stock within your 401k plan.

This can make sense for investors, but you don’t want to invest all your money in your company’s stock as it is too risky.

Rules for 401(k) Withdrawals

For both a traditional 401k plan and a Roth 401k plan, you need to keep the money in the plan until you reach age 59 1/2.

If you withdraw money before this time, you will not only owe taxes on the distribution, but you will owe an early withdrawal penalty as well.

Now there are exceptions to this rule. Here are the exceptions for both types of accounts

Traditional 401k Plan

You can take a 401k loan out, which means you borrow from your retirement plan and then over time you pay it back.

The benefit here is the interest you pay on the loan is also paid back to you.

However, know that your investment would grow into larger sums than if you didn’t use the loan.

Some 401k plans also allow for hardship withdrawals.

Unfortunately, not all plans allow for this and most that do charge a fee for accessing your money.

If you have unreimbursed medical expenses that exceed 7.5% of your adjusted gross income, you can make a withdraw from your retirement savings without paying a fee.

Another situation where you can take from your savings penalty free is if you are required by a court to pay for a divorce.

Finally, there is what is known as a series of substantially equal payments or 72t distribution.

Essentially you are taking a set amount of money from your retirement plan every year for 5 years.

The amount you can take is based on a calculation on the IRS website.

There are lots of rules with this one, so you need to fully understand it before you decide to do it.

Roth 401k Plan

The biggest difference with a Roth 401k is that if you take from your savings early, it is tax free on the contributions you withdraw since you paid taxes before you contributed the money.

However, you do have to pro-rate between contributions and earnings when doing this before age 59 ½, assuming you are withdrawing more than you contributed.

The earnings amount you withdraw is taxable and you would owe the 10% penalty on the earnings amount.

Roth 401k Plan vs. Traditional 401k Plan

As I mentioned earlier, there are two types of 401k retirement accounts.

These are the traditional 401k and Roth 401k.

The main difference between them is how they are taxed upon withdrawal.

With a traditional 401k, you contribute on a pre-tax basis.

This means that you contribute before income taxes are deducted.

You do not pay tax on the contributions until you withdrawal the money.

Meanwhile, with a Roth 401k, you pay taxes before you make contributions.

The good news is that when it comes time to take withdrawals in retirement, the money is 100% tax free.

With both account types, there are required minimum distributions you need to take once you reach age 72.

Frequently Asked Questions

frequently asked questions

Not only is retirement planning confusing, but so are the retirement accounts you can invest in.

This includes 401k plans. Here is a thorough list of common questions I get asked about 401k plans.

Can I change my 401k contribution anytime?

Yes. You have complete control over how you invest your money in your 401k retirement account.

While you are limited to the investment choices of the plan, you can buy or sell as frequently as you like, without worry over income tax.

The only catch to this is some plans may limit you on how frequently you can do this.

This is because trading costs money, and to keep the costs of the retirement plan low, they may put limits on the number of trades you can make in a given year.

So before you decide to trade, review the rules to see if this applies to you.

Also, if you buy and sell frequently, you might not amass the retirement savings you could otherwise achieve if you simply stayed with the same investments for the long term.

How often can I change my 401k investments?

The answer to this varies per 401k plan.

Again, some plans limit you to only making changes once or twice annually.

Others allow you to change your investments as often as needed.

Can an employer automatically enroll you in a 401k?

Yes.

The Pension Protection Act made is easier for employers to auto enroll employees into defined contribution plans.

You have the option to opt out if you do not want to take part in your work sponsored 401k.

Can part time employees contribute to 401k?

This all depends on the benefits offered by your employer.

Some companies offer a 401k as part of the benefits package for part-time employees, while others do not.

If having one is important to you, it makes sense to ask if the company offers a 401k before you get hired.

Can you rollover a 401k while still employed?

This depends on the plan.

Some employers allow you to rollover a 401k plan while still employed.

Others do not allow this.

If your plan allows for rollovers, be sure to review the pros and cons before doing so to make sure it is the best move for your financial situation.

What happens if I leave my job?

If you leave your job, your 401k stays with the company.

If you wish to roll the money over to an individual retirement account or a 401k at your new job, you can do this.

But you don’t have to.

You can keep your retirement savings at your old company and the money is still yours.

Why does my 401k keep going down?

If the stock market is losing value, so too will your 401k.

You have to be patient and give it time.

Over the long term it will grow in value.

Also, if your money is only invested in money market funds or bond funds, you could be losing money because of 401k plan fees.

The fees are taken from your investments and since these investments have a low rate of return, there are times when the fees you are being charged are more than what you are earning.

Are employer contributions to 401k taxable?

The answer is yes and no.

Employer contributions are not taxed when they are made, but the contributions are taxed when you start taking the money out of your 401k.

Also, the contributions your employer makes for you are allowed to be written off against your income taxes the year they are made.

If you are investing in a Roth 401k, any employer contributions are pre-tax and they go into a pre-tax account.

They will grow tax deferred and when you withdraw the money, you will owe taxes on this money.

Is 401k worth it?

A 401k is worth it.

For starters, you contribute money from your paycheck on a pre-tax basis, which lowers your taxable income.

Second, many employers offer a company match.

This is essentially free money that they are putting in your retirement plan for you.

Third, the money you invest in your 401k grows tax deferred.

This means that for all the years the money is invested, you don’t owe tax on the dividends or capital gains your investments produce.

Finally, for many people, it is the best investment they make since they regularly save money every time they are paid.

Can you lose money in a 401k?

Yes you can lose money.

When the stock market falls in value, so too will the value in your 401k.

But you have to remember that the stock market has a positive return over 74% of the time.

In other words, 74% of the years you invest your money, it will grow.

As long as you can be disciplined and stay invested, your balance will grow over time.

What does it mean to max out 401k?

This means you reach the contribution limits allowed by the IRS.

For 2022, this amount is $20,500 for employees under age 50.

For employees over age 50, they can make an additional $6,500 catch-up contribution.

This allows them to save $27,000 for 2022.

Does increasing 401k contribution lower my taxes?

If you contribute to a traditional 401k, your contribution will lower your income taxes.

If you contribute to a Roth 401k, your contributions are made with post-tax dollars and do not lower your taxable income.

What is a profit sharing 401k?

A profit sharing 401k is a type of plan that allows employers to make contributions to employees 401k accounts based on the company’s profitability for the year.

You will find this option available at a small business as they tend to have fewer employees, making this more feasible.

In fact, a small business usually treats the profit sharing contribution as a year end bonus for their employees since they are made around year end.

What is vested balance in 401k?

The vested balance is the money your employer contributes to your 401k on your behalf.

An employer may use a vesting schedule for this money.

Each year, more of the money they contributed to your account is yours to keep.

For example, if 25% vests annually, and your employer contributes $1,000 in your 401k, after 1 year, 25% or $250 is yours to keep.

After the second year, 50% or $500 is yours to keep.

After 4 years, the entire $1,000 is yours.

This is done to protect the employer should you quit your job shortly after being hired.

Understand vesting only applies to the employer portion of the contributions.

All the money you put in to your 401k is 100% yours at all times.

Does employer 401k match count towards my contribution limit?

No, the amount of money your employer contributes to your 401k does not count towards your limit.

Final Thoughts

This beginners guide to a 401k plan included a lot of information.

I know it can be confusing at times.

But at the end of the day, a 401k is an excellent tool for you to use to help you to retire.

You get tax benefits now and as it grows, and if your employer matches your contributions, you get free money as well.

I encourage you to start investing in a 401k plan as soon as you are eligible.

Contribute at least 10%.

If you can’t afford it, contribute enough to get the full employer match.

Then make it a point to increase the amount you save by 1% every year.

By the time you retire, you will have a nest egg that will cover many of your needs.

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