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You’re here because you just accepted a job offering a 401k plan and have no idea if you should invest in it.
Or 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.
There are a lot of questions about this type of retirement account.
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 so you can begin to build your retirement savings.
KEY POINTS
Table of Contents
A Beginners Guide To A 401K Plan
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.
Later in this post, I’ll walk you through the pros and cons of these plan types.
How 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.
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.
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.
As I’ve said, it is basically free money to you.
401k Investment Options
There are two main investment options for your 401k.
Your investments can either be in mutual funds or company stock.
Mutual funds are a collection of stocks, bonds, and alternative investments, like real estate, with professionals managing the investments.
These are the most common investment vehicle since they are low-cost and diversify your risk.
Target date funds have been growing in popularity due to the ease of investing in them, and many plans offer this type of mutual fund to invest in.
Some companies will allow you to invest in company stock.
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 401k Withdrawals
For both traditional and Roth 401k plans, 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.
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 you pay interest back to yourself.
However, know that your investment would grow into larger sums than if you didn’t use the loan.
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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.
There are many rules with this one, so you need to fully understand it before deciding to do it.
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.”
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.
Roth 401k Plan vs. Traditional 401k Plan
As I mentioned, there are two types of 401k retirement accounts, a traditional and a Roth.
The main difference between them is how taxes work upon withdrawal.
With a traditional 401k, you contribute on a pre-tax basis.
This means that you contribute before you pay income taxes.
You only pay tax on the contributions once you withdraw the money.
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Meanwhile, with a Roth 401k, you pay taxes before you make contributions.
The good news is that when it comes time to withdraw money in retirement, it 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
Not only is retirement planning confusing, but so are the retirement accounts you can invest in.
This includes your 401k account. Here is a thorough list of common questions about 401k plans.
Can I change my 401k contribution anytime?
Yes.
You have complete control over investing your money in your 401k account.
While you are limited to the plan’s investment choices, you can buy or sell as frequently as you like without worrying about income tax.
The only catch to this is some plans may limit how frequently you can do this.
This is because trading costs money, and to keep the costs of the retirement plan low, they may limit the number of trades you can make in a given year.
So before you 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 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 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 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?
This is a great question and depends on your individual situation.
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 you 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.
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 you only invest in money market funds, you could lose money because of 401k plan fees.
The fees come from your investments, and since these investments have a low rate of return, there are times when the fees you are paying 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 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.
Can you 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 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.
Final Thoughts
This beginner’s 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 also get free money.
I encourage you to invest in one 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 your savings by 1% yearly.
By the time you retire, you will have a nest egg that will cover many of your needs.
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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.