THIS POST MAY CONTAIN AFFILIATE LINKS. PLEASE SEE MY DISCLOSURES. FOR MORE INFORMATION.
Are you looking to make the most of your 401k plan but don’t know where to start? We’ve all been there, stumbling around in unfamiliar territory. Well fear not. The answers to all of your questions can be found right here.
Get ready for a crash course on everything you need and want to know about how to maximize your 401k from contributing money, the difference between a traditional and Roth 401k, employer matches, and tax benefits. With these tips and tricks under your belt, you’ll be an expert before you know it!
Table of Contents
What is 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.
How do 401k Plans Work?
The plan works by having you make pre-tax contributions from your salary. Your contributions are taken from each of your paychecks during the year and invested in your 401k account.
For example, say you earn $50,000 and 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.
What are 401k Retirement Plan Contribution Limits?
As great as this type of account is, there are limits to how much money you can contribute. For 2023, you can contribute up to $22,500 in elective employee salary deferrals. If you are over age 50, you can contribute an additional $7,500 as a catch-up contribution.
What is 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 regular salary. For example, if your employer contributes $1,000 to your account, 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.
It is usually a percentage match up to a maximum dollar amount. You might see it as a 50% match up to 6% of pay. 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 contribute $2,000 annually. Your employer will put an additional $1,000 into your account. If you still make $40,000 but contribute $6,000 annually, your employer will only match $1,200. This is because 6% of your pay is $2,400, and 50% 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.
Rules for Traditional 401k Withdrawals
For a traditional 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 owe taxes on the distribution and an early withdrawal penalty. There are exceptions to this rule.
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 you pay interest back to yourself. However, know that your investment would grow into larger sums than if you didn’t use the loan. It is important you fully understand the pros and cons of 401k loans before you take out the money.
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 exceeding 7.5% of your adjusted gross income, you can withdraw from your retirement savings without paying a fee.
Another situation where you can take from your savings penalty-free is if a court requires you 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 five years. The calculation to determine the amount you can take is on the IRS website.
What is a Roth 401k Plan?
The most significant difference between a Roth and a traditional 401k is that you make contributions with after-tax money. As a result, when you retire and withdraw the money, you do so tax-free. The after-tax dollars idea is significant, and many people don’t realize the impact this has on your retirement goals.
According to Jonathan Grannick, CFP® at Wonder Wealth, “$20,000 saved to a Roth 401k is truly $20,000. The same amount to a 401k is actually more like $15,000 if you factor in an assumed 25% tax rate that’s taken when they withdraw. This matters because, while on paper a 401k might seem to make more sense, people who save $20,000 to it are not reinvesting the tax savings they get today so they’re actually saving less than the $20,000 they’d be saving to a Roth 401k.”
Rules for Roth 401k Withdrawals
An area of confusion about the Roth version is many people think they are the same as a Roth IRA in that you can withdraw contributions at any time without penalty. With a Roth 401k, you can make an early withdrawal, but you have to prorate it. This means you must determine your balance’s makeup and withdraw accordingly.
For example, say your account balance is $10,000, of which $8,000 is contributions and $2,000 in earnings. The earnings ratio is 20%, so if you withdraw $5,000, you will classify $4,000 as contributions and $1,000 as earnings. When doing this before age 59 ½, you would report the $1,000 as taxable income and pay taxes and the 10% penalty on it. The other $4,000 would not incur any taxes or penalties.
Can I Change my 401k Contribution Anytime?
Yes, most plans allow you to change the amount you contribute to your 401k at any time. When you do make a change, it will go into effect either with your next paycheck or the following one, as your employer needs to submit the request. Depending on how close it is to payday will determine how soon the change will be made.
How Often an I Change my Investments?
The answer to this varies per 401k plan. 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 me in a 401k?
Yes, the Pension Protection Act made it easier for employers to auto-enroll employees into defined contribution plans. You can opt-out if you do not want to participate in your work-sponsored 401k.
Can Part-Time Employees Contribute to a 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, asking if the company offers a 401k before you get hired makes sense.
Are There Income Limits for Contributing to a Roth 401k?
Unlike with a Roth IRA, there are no income limits to contribute. This allows high earners to save in a Roth-like vehicle that they otherwise would not be able to use because their income is too high.
Should my 401k Investment be a Traditional or a Roth?
As David A. Fowler, CFP®, ChFC® of High Mountain Financial Coaching LLC, says, “The decision of whether to invest in a traditional 401k versus a Roth 401k is mainly driven by taxes – both today and what you as an investor believe your tax situation will be in the future at retirement. If you are a high-income earner now and believe your income will be lower in retirement – taking the tax deduction now will lower your immediate tax bill. If you expect to have similar (or higher) income at retirement, it may make more sense to take the tax hit today, invest in a Roth and be able to pull that money tax-free at retirement.”
Can I Roll Over a 401k While Still Employed?
This depends on the plan. Some employers allow you to roll over your plan while still employed. Others do not allow this.
If your plan allows for rollovers, 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. You can do this if you wish to roll the money over to an individual retirement account or a 401k at your new job. But you don’t have to. You can keep your retirement savings at your old company, and the money is still yours.
Are Employer Contributions to 401k Taxable?
The answer is yes and no. Employer contributions are not taxed when made, but they are taxed when you start taking the money out of your account. Also, your employer’s contributions 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 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 they are putting in your retirement plan.
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 get paid. You can see the impact of saving for retirement in a good retirement calculator.
Can I Lose Money in a 401k?
Yes, you can lose money. When the stock market falls in value, so will the value of your plan.
But you have to remember that the stock market has a positive return over 74% of the time. In other words, it will grow 74% of the time you invest your money. As long as you can be disciplined and stay invested, your balance will grow over time.
What Does it Mean to Max Out my 401k?
This means you reach the contribution limits allowed by the IRS. For 2023, this amount is $22,500 for employees under age 50. Employees over age 50 can make an additional $7,500 catch-up contribution. This allows them to save $30,000 for 2023.
Does Increasing my 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 contribute to an employee’s retirement account based on the company’s annual profitability. This option is available at a small businesses as they tend to have fewer employees, making this more feasible.
A small business usually treats the profit-sharing contribution as a year-end bonus for their employees since most companies make them around year-end.
What is the 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 money they contributed to your account is yours.
For example, if 25% vests annually, and your employer contributes $1,000, 25% or $250 is yours to keep after one year. After the second year, 50% or $500 is yours. After four years, the entire $1,000 is yours.
This protects the employer should you quit your job shortly after being hired. Understand vesting applies only to the employer portion of the contributions. All the money you put into your 401k is 100% yours at all times.
Does my Employer 401k Match Count Towards my Contribution Limit?
No, the amount of money your employer contributes to your account does not count toward your limit.
This article originally appeared on MoneySmartGuides.
I have over 15 years experience in the financial services industry and 20 years investing in the stock market. I have both my undergrad and graduate degrees in Finance, and am FINRA Series 65 licensed and have a Certificate in Financial Planning.
Visit my About Me page to learn more about me and why I am your trusted personal finance expert.