Welcome to Chapter 5! This chapter is all about one of the most popular retirement savings vehicles in the United States: the 401(k) plan. Named after a section of the Internal Revenue Code, 401(k) plans are employer-sponsored retirement savings plans that offer significant tax advantages and the potential for matching contributions.
In this chapter, we’ll go over the basics of how 401(k) plans work, including the types of contributions, tax benefits, withdrawal rules, and the impact of vesting schedules on your savings. We’ll also touch on the important role that 401(k) plans can play in your overall retirement planning strategy.
Understanding 401(k) Contributions
401(k) plans are funded through pre-tax deductions from your paycheck. You can choose how much of your salary you want to contribute, up to a limit set by the IRS. The contribution limit is $19,500 per year for those under 50, and $26,000 for those 50 and older. This limit may have been adjusted for inflation in the since I wrote this, so it’s always a good idea to check the current year’s limits.
The money you contribute to your 401(k) grows on a tax-deferred basis. This means you won’t pay taxes on your contributions or their earnings until you withdraw them in retirement.
Many employers also contribute to their employees’ 401(k) plans through a matching program. Employer matches vary widely, but a common structure is a 100% match on the first 3% of salary that an employee contributes, and then a 50% match on the next 2%. This means that if you contributed 5% of your salary to your 401(k), your employer would add an additional 4% of your salary into the plan. These employer contributions can significantly boost your retirement savings, but it’s important to understand the plan’s vesting schedule, which we’ll discuss in a later section.
Tax Benefits of 401(k) Plans
One of the significant advantages of a 401(k) plan is its tax benefits. When you contribute to a traditional 401(k) plan, your contributions are made with pre-tax dollars, which means that you can reduce your taxable income for the year. This immediate tax break can be a substantial benefit if you’re currently in a high tax bracket.
The money in your 401(k) grows tax-deferred, meaning you won’t pay taxes on your investment earnings as long as the money remains in the plan. This allows your savings to grow faster than they would in a taxable account, thanks to the power of compounding.
However, keep in mind that you will need to pay income taxes on your 401(k) withdrawals in retirement. The amount of tax you’ll owe depends on your tax bracket in retirement, which may be lower than your current one, potentially giving you a further tax advantage.
Withdrawal Rules and Penalties
Understanding the rules and potential penalties for withdrawing from your 401(k) is crucial. Generally, you can start taking distributions from your 401(k) without penalties when you reach the age of 59 and a half. Withdrawals made before this age are subject to a 10% early withdrawal penalty, in addition to regular income tax.
There are some exceptions to this early withdrawal penalty. For instance, if you leave your job during or after the year you turn 55, you can start taking distributions without the 10% penalty. Other exceptions include disability, certain medical expenses, and a part of a series of substantially equal periodic payments.
Once you reach the age of 72, you will need to start taking required minimum distributions (RMDs) from your 401(k). These are minimum amounts that the IRS requires you to withdraw from your account each year. If you don’t take these distributions, or if you withdraw less than the required amount, you may have to pay a 50% excise tax on the amount not distributed.
Understanding Vesting Schedules
Vesting schedules determine when you gain full ownership of the employer contributions to your 401(k). You are always 100% vested in your own contributions. However, your employer can stipulate a certain period of service before you are fully vested in their contributions.
There are three types of vesting schedules. With cliff vesting, you become fully vested after a specific number of years, typically three years. With graded vesting, a certain percentage of vesting occurs each year until you’re fully vested, usually over six years. Immediate vesting means you’re vested in your employer’s contributions right away.
Understanding the vesting schedule at your job is crucial. If you leave your job before you’re fully vested, you could lose a significant portion of your 401(k) balance. Make sure to factor this into your decision if you’re considering a job change.
401(k) Loans and Hardship Withdrawals
In certain circumstances, you may be able to take out a loan or make a hardship withdrawal from your 401(k). This can provide you with access to funds without the 10% early withdrawal penalty, but it’s important to understand the potential impacts on your retirement savings.
A 401(k) loan allows you to borrow against your account balance, up to a limit. You then repay the loan with interest back into your 401(k). While this can provide short-term financial relief, it can also derail your long-term retirement savings plan. The money you borrow won’t be invested, potentially missing out on growth.
Hardship withdrawals are allowed for immediate and heavy financial needs, such as medical expenses, tuition fees, or avoiding eviction or foreclosure. However, you’ll still need to pay taxes on the withdrawal, and you may not be able to contribute to your 401(k) for six months after the withdrawal.
In the next chapter, we’ll shift focus to another employer-sponsored retirement plan: the pension plan. Despite being less common in recent years, understanding how pension plans work is crucial for those fortunate enough to have access to them.