What is a 401(K) plan and how does it work?

If you are interested in retirement savings and meeting your financial goals, making contributions to your 401(k) plan is a great way to start saving for retirement. So, what is a 401(k) plan, and how does it work?

A 401(K) retirement plan allows you to contribute before-tax wages toward retirement savings through payroll deductions. Once you qualify for this plan, you will sign up and decide how much you want to contribute. The 401(k) plan offers direct tax benefits, and you can grow the account on a tax-deferred basis. However, you pay income tax on your distributions during retirement.

Some companies match your contributions to a certain percentage of your gross income. For example, your company can match your contributions up to 6% of your gross income.

Here is everything you need to know about 401(k) plans and how to use them as part of your wealth-building strategies.

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When can I sign up for a 401(K)?

Since the 401(k) plan is offered through an employer, you must meet your company’s requirements before signing up for a 401(k) plan. After getting hired, your company will have rules that govern eligibility for 401(K) plans.

For example, most companies will not allow you to sign up for 401(K) plans until you have worked there for 90 days. Others require a year of service. After meeting the company’s requirements, an account will be opened on your behalf, allowing you to start making contributions. Saving for retirement early will enable you to maximize your 401(k) tax benefits and grow your wealth quickly through compounding interest.

How much can you contribute to a 401(K) plan?

Now that you know what a 401(K) plan is, how much can you contribute? The IRS changes 401(k) contribution limits yearly in response to economic conditions.

For 2024, the contribution limits to a 401(K) plan are $23,000 or $30,500 if you are 50 or older. For 2023, you can contribute up to $22,500 or $30,000 if you are 50 or older to your 401(k) plan.

How much should you contribute to your 401(K) plan?

One of the best ways to secure a comfortable life during retirement is to start saving as early as possible. The compounding effect on your portfolio allows you to grow your nest egg faster and effortlessly.

Successful investments rely on compound interest principles. As you earn interest, it gets reinvested and earns you more. This process continues until your account grows exponentially.

So, how much should you contribute to your 401(K)?

You may be thinking about contributing the maximum allowed by the IRS. Although this sounds like a great trick to lowering your taxable income, it may not be your best option. So, what is the best way to contribute to your 401(K) plan?

You should contribute to your employer’s match percentage as a starting point. Once you reach this level and still have money to contribute, consider maxing out an individual retirement account (IRA). If you have more money to invest after maxing out your IRA, add it to your 401(K) account until you reach the contribution limits on 401(k) for the year.

By having an IRA, you will take advantage of other benefits unavailable for 401(K). For example, the 401(k) plan comes with limited investment options tied to the plan. On top of that, these plans have higher fees. The fees you pay will depend on your investment options and the number of participants in the plan. The more people participating in the plan, the lower the fees.

By having an IRA, you will avoid higher fees and have a great range of investments.

What are the benefits of 401(K) plans?

A 401(k) plan saves you money in taxes and allows you to save for retirement faster.

Here are the benefits of 401(k) plans you should know.

The 401(k) boosts your savings. The core benefit of a 401(k) plan is that it allows you to increase your savings for retirement faster.

A 401(k) offers a lot of tax advantages. By investing in a 401(k) plan, you can defer your taxes on the contributions made until retirement.

Employer match contributions. Many employers offer to match a percentage of your contributions, providing you with essentially free money towards your retirement.

Loan options. With a 401(k) plan, you can borrow against your account, providing easy access to funds when needed.

Control over investments. You can choose from various investment options inside the plan based on your financial goals and risk tolerance.

You can take your 401(k) with you. If you change jobs, you can rollover your 401(k) funds into another 401(k) plan.

Drawbacks of 401(K) plan

While the 401(k) plan comes with many benefits, you should also be aware of the disadvantages of the 401(k) plan.

Here are 401(k) drawbacks you should keep in mind.

401(k) plans come with limited investment choices. Most 401(K) plans offer a selective range of investment options, typically consisting of a mix of mutual funds.

High fees. 401(K) plans often have high fees that can significantly erode your retirement savings. 401(k) fees include plan administration, investment, and individual service fees.

Early withdrawal penalties. If you need to access your retirement savings before age 59½, you’ll likely incur a 10% early withdrawal penalty.

Mandatory distributions. Once you reach age 73, you must start taking minimum distributions(RMDs) from your 401(K) plan, regardless of whether you need the money.

Loan restrictions. While it’s possible to take a loan from your 401(K), there are strict rules regulating this process. If you can’t repay the loan within the specified time frame, it could be considered a distribution and will be subjected to taxes and penalties.

Market risk. 401(k) money is generally invested in the stock market, which means your retirement savings are exposed to market volatility and risk.

Limited control. Compared to other types of retirement accounts, such as IRAs, you have limited control over your 401(K).

Employer match restrictions. Although employer matching is a significant advantage of 401(K) plans, it often comes with strings attached. For example, your employers may require you to work a certain number of years before they are fully vested.

401(k) early withdrawal penalty

The Internal Revenue Service requires that you reach 59½ before you can take distributions from your account without a penalty. If you make early distributions, you will pay a 10% penalty and taxes on the money withdrawn.

The only way to avoid this penalty is by meeting the IRS exceptions.

Required minimum distributions (RMDs)

The 401(K) plan comes with required minimum distributions(RMDs) when you turn 73. RMDs are mandatory distributions you must take from the account to pay the tax that was deferred. Failure to take RMDs may result in a 50% penalty for the money you did not withdraw on time.

Other accounts that require RMDs when you turn 73 include traditional IRAs, traditional IRA-based accounts, 403(b) plans, and 457(b) plans.

Alternatives to a 401(K) plan

Sometimes, you will end up at a job with no retirement benefits. The lack of 401(k) benefits with your job does not mean you cannot save for retirement. Other accounts could offer you similar retirement benefits. If you don’t have 401(k) from your job, opening an IRA will be your next best chance to save for retirement.

You can easily open an IRA from your bank, online brokerage firm, or investment company with retirement saving services. You can either open a traditional IRA or a Roth IRA.

If you choose to open a Roth IRA, your contributions will not give you upfront tax benefits as they come from after-tax wages. The advantage of a Roth IRA is that your account will grow free of taxes, and qualified distributions will be tax-free during retirement.

If you open a traditional IRA, your contributions might be tax-deductible based on your filing status and income limits. You will then defer tax on your account until retirement when applicable tax is applied to your distributions.

If you own a small business, here is a guide to saving for retirement when you are self-employed.