How Does A 401k Work | How Much To Contribute | 401K Complete Guide
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How Does A 401k Work | How Much To Contribute | Guide

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Updated December 17, 2022

Allyson Krause CRPP™, Managing Director Retirement Plan Services

So, you’re wondering – how does a 401k work? The 401(k) is the most commonly used private retirement account in the U.S. today. If you have a 401(k) provided by your employer, it can be an important vehicle for saving for retirement. Below is a guide to the 401(k) to help you figure out how this account works, how you can contribute to it, and how much of a part it should play in your retirement savings plan.

What is a 401(k)?

A 401(k) is a qualified retirement plan that allows eligible employees of a company to save and invest for their retirement on a tax-deferred basis. Depending on the type of 401(k) you choose to contribute to, Traditional or Roth, the tax deferment can be on a pre-tax or post-tax basis.  

A traditional 401(k) plan takes contributions from your paycheck and deposits them in an account before any taxes are taken out of your pay. Taxes are paid when you begin withdrawing from this account. A Roth 401(k) takes contributions from your paycheck after taxes are deducted. Under a Roth plan, no taxes are paid at the time of withdrawal.

Your options for investing within the 401(k) are determined by what your employer offers. The average plan today offers nearly two dozen investment options. No two employers may be the same; it just depends how each plan is administered. Some plans allow for participants to choose their investment options and asset allocations, while others will employ professionals to manage the fund directly.

What are the rules for withdrawal?

A 401(k) has several important rules regarding how and when a withdrawal can be made.  You can start taking withdrawals, without penalty, at the age of 59 ½. Usually, a contributor must start taking withdrawals from the account at the age of 70 ½ unless the participant is still working and the plan allows for the required distribution to be deferred. Withdrawals can be made before retirement age, but a 10% early withdrawal penalty will be assessed by the IRS along with the amount withdrawn being taxed as ordinary income unless an exception applies.  

Exceptions include:

  • Death or disability
  • You end your employment during or after the calendar year that you turn 55.
  • You withdraw for qualified medical expenses exceeding 10% of adjusted gross income.
  • The distributions are taken as a series of equal periodic payments over the participants life or the joint lives of the participant and a beneficiary.
  • The distribution is made under a qualified domestic relations order (QDRO) to an alternate payee.

If these exceptions apply, then you don’t incur the 10% penalty, but the funds will be taxed as ordinary income at the appropriate rate.

You may also take a loan against your 401(k) if your plan allows it. If you are allowed to take a loan against your 401(k) account, usually it is only against the vested balance, and for specific reasons such as medical expenses or first-time home-buying. You will have to consult your plan for specific details on acceptable loan reasons and interest rates. Generally, loan payments can be directly deducted from paychecks and are not subject to penalties or taxes. If you terminate your employment before the loan is repaid, the outstanding amount is considered income.

What is a rollover?

A rollover is a process by which you can move your 401(k) funds into an IRA account. This movement of funds between accounts will allow them to maintain their tax-protected status as long as you’re moving them between similar accounts (i.e., Traditional 401(k) to traditional IRA as opposed to a Roth IRA). You might choose to rollover your funds for several reasons.  The most common reason is due to a change in employment. When you change jobs, instead of keeping your funds with the current 401(k) plan, you may want to consolidate your retirement savings into one account for tracking and simplicity. Some people also rollover their 401(k) funds to an IRA so that they can have more investment choices than what is available at their current employer.    

How much can I invest in a 401(k) account?

401(k)s have contribution limits. View the latest limits set by the IRS.

How much should I contribute to my 401(k)?

Now that we understand how a 401(k) works, we’ve got to decide what makes sense to contribute to the plan. There are several considerations that will affect your decision.

Employer Matching

The first thing you should consider is your employer matching funds. Most employers offer some sort of matching funds up to a certain amount. Usually, it makes sense to at minimum contribute enough to max out the employer contribution. This is “free money” on top of your contribution and can represent an upfront 30-100% return on your contribution.

Financial Goals

Whether you contribute beyond the employer match will then depend upon your goals and how you want to manage your taxes. If you’re someone who is looking at aggressively saving for early retirement, then you may want to contribute as much as your budget allows for into a 401(k).  

A consideration you might have when you are early in your career is whether you want to contribute more money to a Roth IRA instead of extra contributions to your 401(k). Since you will have 20 to 30+ years to allow that contribution to grow tax-free, and when you withdraw that money all of the earnings will be tax-free. Unlike the 401(k) contributions which will be taxed at your tax rate at the time of withdrawal.

Emergency Savings

Another consideration is that since 401(k) money can rarely be drawn on without penalties and taxes, it’s a poor vehicle for emergency savings. With a Roth IRA you can withdraw all of the original contribution amounts, but not your earnings, tax and penalty free. So if you want to start aggressively saving for retirement, but need to build an emergency fund, it might make sense to focus on a Roth IRA for retirement savings.  

Strategy

From an overall financial strategy standpoint, a lot of people will want to contribute to their 401(k) up to the point at which they max out the employer contribution so that they can get the maximum dollar for dollar contribution. Once that is done, then maxing out the Roth IRA is a good second priority because of the tax advantages and financial flexibility. If you still have extra contributions to make after you reach the limit on your Roth IRA, you can try to max out what remains of your 401(k) limit.  

Trust Point can help to figure out your 401(k) contributions

What is the best retirement savings strategy for you? There are many factors to consider: plan options, employer contributions, retirement horizon, tax impacts, etc. A Trust Point retirement professional can help create a customized retirement contribution strategy for you.  Contact us today to get started!

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Allyson Krause CRPP™, Managing Director Retirement Plan Services