After spending your whole life working, you want to have peace of mind that you’re covered financially when you retire, and a 401k is the ultimate savings plan that makes this a possibility.
Many Americans already have a 401k in place, but even those that do still have many questions about these retirement plans that go unanswered.
So, how does a 401k work exactly?
These investment vehicles are like a special type of savings account where employers put a portion of their salary away until retirement, not paying tax on their money until it’s been withdrawn.
Although it might sound simple enough, there are many finer details that can make this retirement savings vehicle confusing, but it’s something that anyone with a future plan for their money needs to be aware of.
This guide can answer all of the common questions regarding 401k, but most importantly, how does a 401k work?
Knowing the ins and outs of these financial plans will put you in the best position to use them wisely and set yours up the correct way so that it can serve you well when it finally comes time to retire.
How Does a 401k Work?
A 401k is like a personal savings account that people put a portion of their paycheck into to save for when they retire, getting access to their funds when they stop work.
Rather than just putting that money aside into your own savings account, a 401k comes with specific benefits that make them more attractive.
The money is invested in a number of options that you can decide on, including stocks and bonds, rather than just sitting there over the years in a separate account.
A 401k account is sponsored by your employer, letting you make tax-deferred contributions from your salary.
You’ll be given the option to pay tax on them now or later once you withdraw the money, with most people choosing to defer tax until they take their money.
Anything you earn while the money is in your 401k will also be accrued on a tax-deferred basis.
When your 401k is organized through your employer, they might also offer a matching system or contributions on their behalf so that you’re earning more than just what you put away.
This isn’t always an option though and each employer will have their own benefits to offer, which should be considered along with a salary package.
Once you’ve retired, you’re able to withdraw your money in bits and pieces to use as you wish.
However, there are some caveats in place about 401k accounts that require some research so you can be sure that you’re getting the very best use out of them.
What Is a 401k?
The 401k retirement plan was initially used as a way to supplement the aged pension, but today most employers use a 401k instead of these plans because they’re more affordable to manage.
With a 401k, the employee is able to choose how they invest in their money by selecting from different options, including:
- Stock funds: A variety of stocks that you can invest in, with lower costs and long term returns being the best option.
- Target date funds: Based on the date of your retirement, these funds are pretty low maintenance and can be adjusted over the years to match your assets.
- Blended fund investments: A mixture of both stocks and bonds that you can choose depending on how long you have to invest.
- Money market funds: The least popular option as these funds are unable to keep up with inflation.
- Bonds: A safer way to invest and make sure you don’t lose money, but not as good at growing it.
When you start a 401k, your employer will usually select a default investment option, but you have the right to change this as you wish.
You will get at least three investment choices which you can mix and match to your preference, and they are usually categorized by the level of risk the investment comes with.
For specific employer contributions, you will only be able to use the investment choice they have chosen for you, but some may allow flexibility.
Usually, as people near closer to retirement age, they prefer low risk or conservative investment options that will ensure they get to keep the balance they’ve already acquired.
Younger 401k owners might choose riskier options designed to make more money over the long term, but it will depend entirely upon the individual’s preference.
How Do You Start a 401k?
Whether you’ve just started a new job, joined the workforce, or are making plans for retirement, your 401k will be a huge priority.
The process for setting the account up is pretty straightforward, but depending on much say you want on it, it could get quite complex.
Most people will set up their initial 401k with their employer but you might also choose to use a financial advisor or another form of assistance to help with the process.
You’ll be required to sign a legal document regarding the account and most are based on standard templates, so they usually don’t take much effort at all.
As you’re setting up the account and creating a plan, you’ll be asked a number of questions about specifics like what percentage of your wages or salary you want to put away, the investment schedule you’ve chosen, employer matching and contributions, and whether you want to utilize loans at some point.
Once your plan document and agreement are in place, you’ll also need a trustee which is usually an employer, but if you’re self-employed this could even be yourself.
The role of the trustee is to ensure that the plan is legal and follows the rules which can be a huge responsibility.
With everything agreed upon, your 401k plan will begin and you’ll notice the regular amount starting to come out of your paycheck.
Where Can You Find Your 401k Details and Plan?
Most people want to keep an eye on their 401k account and its details to see how it’s tracking.
As these are usually organized through an employer, they will be able to give you the information needed to access this information which is usually with a separate entity like an investment provider.
Investment providers are like 401k vendors and this is where you’re sending the actual contributions that you’re making.
They’re usually larger financial companies who keep hold of your money, send you regular statements about your money, and operate online portals or websites where you can change or update your details and investment choices as you choose.
How Much Is Your 401k Worth?
Each person has their own 401k plan in place and many factors that will determine what it’s worth when you’re finally ready to retire.
If you’re wondering how much your 401k is worth and want a more specific calculation that you can rely on, consider these variables and how they might apply to you:
- The current balance of your 401k;
- The date or age that you plan on retiring;
- The current match rate that your employer offers on contributions;
- Your annual salary and what additional income you might receive in the future;
- What percentage of your income you’ve chosen to contribute;
- How much your investment options are returning;
Obviously, there are ways that you can increase your 401k’s worth so that you end up with more money at retirement, but some things can’t be guaranteed, like investment earnings.
When looking at the modern history of the stock market though, these investments have averaged returns of around 10% per year, with fixed-income investments like bonds making around 5%.
How Much Will I Need in My 401k To Retire?
One of the most important calculations you’ll need to make regarding this savings account is how much you’ll actually need in your 401k to retire one day.
This figure will differ for each person depending on their own financial situation, but there are a few things to consider that will help you come closer to that magic number:
The current age for full benefits of retirement in the US is just over 66 years, but from the age of 70.5, you will need to start taking required minimum distributions from your 401k account.
The current life expectancy in the US is 78.7 years, according to the CDC, which means you’ll need 8 – 12 years of income to survive on, as a general figure.
Cost of living
Everyone’s cost of living will differ depending on their lifestyle choices, where they choose to retire, and what their financial needs will be at that time.
You’ll need enough money to be comfortable during retirement without having to rely on anything else.
Whether or not you own property or have other assets and investments should also be factored in.
Obviously, someone still paying a mortgage or needing to rent their home will have more costs to factor in that someone who owns their home outright.
Factor in how much tax will be taken from your 401k when you retire and these are calculated on an incremental basis.
You’ll need to understand the tax requirements for your state to get a better idea of what’s going to come out of your final account.
Pension or supplemental income
Will you have any other form of income to live off when you retire, like a pension plan or income from property that you already own?
This could impact how much you’ll need from your 401k to live comfortably.
Are There Limits on How Much I Can Contribute?
The government has set limits in place that determine how much an individual can put into their 401k account each year.
However, your employer might also have limits in place that they’ll allow you to take out of your salary, so both have to be considered.
Your personal limit will depend on a few factors including employer guidelines and your salary, but as a rule, you can follow the government guidelines to see what the cap is each year.
For 2019, the maximum contributions allowed were $19,000, compared to $18,500 in 2018.
Over the last 10 years, this limit has increased in $500 increments each year to meet the cost of inflation and is expected to follow this trend.
For older 401k account holders, there is something called a ‘catch up contribution’ that can be utilized to help you put away more.
If you’re over 50 years of age, you can put an additional $6,000 into your account each year on top of the government cap, giving those closer to retirement a chance to save more money.
Some employers will only match up to a certain percent of your contributions but whatever they do match into your account won’t be part of these initial limits.
Anything you contribute personally after tax or anything your employer contributes is allowed to reach a limit of up to $56,000 as per the figures for 2019.
How is a 401k Withdrawal Taxed and Calculated?
When it comes time to withdraw your from 401k, you’ll then be responsible to pay the tax that you deferred the contributions you made.
As this portion of your income wasn’t taxed when you put the money aside, it will eventually be taxed when you make a distribution, and this is generally treated like any other income.
Any distribution taken from a 401k account is taxed on the basis of amount, with the more money you have the higher the rates.
People who earn money from other sources of income will have to take this into consideration as well and make sure they calculate for the 401k balance on top of it.
As of the 2018 tax year, there were seven brackets that income could fall into and your 401k is part of these calculations as well.
A married couple with a joint income of $80,000 would be required to pay an initial 10% on the first $13,600, 12% on the next $38,200 and then 22% on the remaining balance.
If they earned more than that and went into the next bracket, this would then go up to 24% on the remaining balance.
This figure changes each year and is sometimes subject to cuts or hikes, but it’s fairly easy to estimate what the amount might be.
Can You Roll Over a 401k and Why Would You?
Most people will change their employer at least a couple of times through their working lives, and when you do you’ll need to take into consideration your 401k.
A new employer will walk you through the steps of setting up your 401k account when you join them, but you will be responsible for ensuring you roll over any existing balance you have in another fund.
There are cases where you might be eligible to receive your 401k in full when you exit a job, but in addition to penalties and taxes that this comes with, it will mean your savings account will have to start from zero again.
Therefore, it’s the smartest approach to roll the funds either into your new 401k or an IRA.
Technically, you can leave your money with the old account as long as you want, with most having stipulations that they can’t be touched even if you no longer work with that employer.
However, to ensure you have a healthy balance and are managing your money well, you should speak with your plan administrator and new employer to ensure that you move the funds over.
As long as you follow the rules, you shouldn’t be met with any penalties and will be able to join the two accounts together.
What Is a Roth 401k And How Does It Work?
A Roth 401k is another option that you might want to consider when planning for your retirement, but it’s targeted at a specific group of people.
Usually, tax payments are deferred when making contributions into your 401k, but with a Roth 401k, you actually fund the account with after-tax dollars instead.
The purpose of a Roth 401k is to help people who think they might be in a higher tax bracket by the time they retire.
By paying tax now rather than later, you’ll be hit with a lower tax rate that in the future, and it will end up being the smarter option.
These hybrid retirement savings plans use a mixture of both 401k and Roth IRAs, and while there are no limits on income there are limits to contributions based on your age.
Some people might even like to hedge their bets and make contributions to both a Roth 401k and standard 401k, and as long as your employer allows it you might want to consider this.
In 2019, the limit on Roth 401k contributions is $19,000 a year, the same as a standard 401k.
Any withdrawals made at retirement won’t be taxed, but they have to be classed as a qualified distribution.
Once you reach 70.5 years of age, you are required to start taking distributions, unless you’re still employed.
How Do I Make the Most of My 401k?
Your 401k is one of the most important financial plans you’ll ever be a part of.
Knowing how to make the most of it and ensure you have a healthy nest egg for retirement is something that everyone should be doing, so here are some tips for ensuring it’s enough to survive on.
- When you’re choosing an investment plan, think long term. Have a smart asset allocation strategy and think about what can happen to it over the years that you’re working.
- An employer might be able to offer professional investment advice, but be wary of paying for it. Avoid advisors who want to take a percentage of your portfolio for this type of help.
- Avoid the urge to withdraw anything from your 401k before you retire. There are emergency situations where you might have no choice but to use some savings, but be prepared to pay taxes and penalties to make it happen.
- Take full advantage of whatever your employer offers in matching contributions. This is essentially free money that can be added towards your savings.
- Be vigilant in keeping an eye on your account and making a note each year of what’s happening with your balance. You should know about your own 401k account and what all of it means.
401ks can seem confusing at first, but they’re pretty straightforward once you learn more about them.
We’ve got the answers to some commonly asked questions regarding these retirement savings vehicles so that you don’t have to wonder anymore.
Is 401k Mandatory?
There is no law in place that states you have to have a 401k account and it is a completely voluntary process.
However, employers are required to enroll you in some sort of retirement plan but there is always the option to opt out.
Can You Lose Money in a 401k?
A 401k is an investment plan and there is always a risk that comes with investing. However, they are generally designed to accrue money over the years and not lose it.
Even if an employer terminates business or goes bankrupt, your 401k account will be safe. The only real way to lose money from these accounts is with penalties and taxes.
When Was the 401k Invented?
In 1978, Congress passed an act that gave workers a way to have a tax-advantaged savings account by deferring any profits earned from stock options or bonuses they might have received.
Although initially it was just intended as an additional investment opportunity, it quickly became the main way that people started to save for their retirement.
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