401(k)s are one of the most widely known retirement accounts. These are sponsored by your employers and, like IRAs, offer tax benefits based on which type you choose. Despite being the most widely known, a majority of people with access to them are still confused about what they are and how they work. Read on to finally understand what a 401(k) is.
What is a 401(k)?
A 401(k) is an employer-sponsored retirement account, meaning you will have access to this type of account through your job. Through this account, you will divert an elected percentage of your pre-taxed earnings to go straight into your account. Whether or not your employer offers a “match” on your contributions may influence your decision regarding how much to contribute per check.
Why is it called a 401(k)?
The 401(k) account gets its name through the section in the IRS code that lays out its terms. Section 401 subsection (K) of the code allows companies to offer tax-advantaged retirement savings plans to their employees to encourage people to save for their own retirement. The government sees this as beneficial because this would mean there is less of a strain on government public support, like Social Security or Medicare. Relying on Social Security as your sole source of retirement income is not recommended, as it’s not meant to fully replace your current income. The average Social Security benefit was $1,503 per month in January 2020. The maximum possible Social Security benefit for someone who retires at full retirement age is $3,011 in 2020. This is why using other investment vehicles to save for retirement, like a 401(k), is so important.
How To Sign Up For A 401(k)
You can sign up for a 401(k) when you start a new job, HR should provide you with your benefits package when you accept your job offer. Keep in mind that there may be a waiting period of up to 1 year before you’re eligible to contribute to the plan. If that is the case for you, you may want to set up an IRA in the meantime, to continue saving for retirement.
Here’s the basic process for signing up for a 401(k):
- Sign onto your employer’s plan
- Elect your per-paycheck contribution amount in the form of a percentage
- Choose which of the offered stocks and funds you will be investing your contributions in
- The percentage you have elected is automatically taken out of each paycheck before it lands in your banking account and invested into your chosen sources
The contribution limits adjust every few years to account for inflation. For 2020,
- Employees can contribute up to $19,500 to their 401(k) plan for 2020, up $500 from 2019.
- Anyone age 50 or over is eligible for an additional catch-up contribution of $6,000 in 2019 and $6,500 in 2020.
What is an employer match?
A key part of the process is to look for the word “match” in your handbook or Human Resources presentations. An employer-sponsored match is free money, so always look for that word “match.” If your employer doesn’t offer a match, you may want to think through whether a 401(k) or an IRA makes the most sense for you.
A 401(k) is a great option when your employer offers a match, which often comes in the form of a dollar-to-dollar or 50 cents to the dollar match to your contributions up to a certain limit. For example, let’s say you make $70,000 a year and your employer-sponsored 401(k) match is 50% up to the first 5% you contribute. Contributing 5% of your total earnings would equal a $3,500 contribution. Because of the employer match, your employer will then give you 50% of your $3,500 contribution, which would be another $1750 in free money.
What Does It Mean to Be Vested in My 401(k)?
Putting it simply, vested is a term used to determine how much of your 401(k) funds you can take with you when you leave your company. Vesting refers to the ownership of your 401(k).
While all the money that you personally have contributed to your 401(k) is yours and will go with you if you choose to leave your position, the terms may be a bit different when it comes to your employer’s match of that money. Many employers set up vesting guidelines regarding what they contribute to their employee’s 401(k)s.
Many companies’ policies range from three to seven years in order for you to be fully vested in your 401(k). Some may allow you to be vested for a percentage of that amount, which increases each year until you reach the maximum amount.
What Happens If I Leave Before I Am Fully Vested in My 401(k)?
Let’s say you have a plan that increases the amount you are vested in your plan each year by 20%. This means that you will be fully vested (i.e. the employer-matching funds will belong to you) after five years at your job. But if you leave your job after three years, you will be 60% vested, meaning that you will be entitled to 60% of the amount of money that your employer contributed to your 401(k).
If your employer does not have a plan that increases your vested amount each year but instead becomes fully-vested when you’re at the company for a certain period of time, you will lose all the money your employer has contributed to your 401(k) plan if you leave before that period is up.
So be sure to familiarize yourself with your employer’s vesting policy, or it could cost you big. You may even consider staying at your job longer than you originally planned in order for your 401(k) to fully vest.
Benefits of a 401(k)
The employer contribution match offers the main benefit of a 401(k). No other retirement savings account (or investment account for that matter) will give you free money like this. Other benefits include:
- Pre-tax contributions
- Automated contributions
- Tax-free growth
- Income bracket deduction
Now, the listed benefits depend on the type of account you choose to get. There are two types, but not all employers will offer both:
Tax Perks of Traditional 401(k)s
In a traditional 401(k), you have access to several tax benefits:
- At the contribution phase, since all the money you contribute (up to the annual limit) is tax-deferred, meaning you won’t pay taxes on that money until you withdraw it in retirement.
- During tax time, since your pre-tax contributions will not count towards your annual earned income, which could place you in a lower tax bracket
- As your account grows, since the growth in value will be tax-deferred, thus allowing your growth to earn money (compounding!) within the account.
Tax Perks of Roth 401(k)s
In a Roth 401(k), the tax breaks are similar, except flip them to be applicable upon withdrawal:
- At the contribution phase, you will be contributing post-tax, so you don’t get any immediate tax benefit.
- At the tax stage, your income will be the same.
- And at the growth stage, your growth will be tax-free, rather than tax-deferred. This means your withdrawals will be tax free!
The key difference and potential benefit over the Traditional 401(k) is in the last stage. Rather than earning the tax break now (as you would in a Traditional 401(k)), your tax break will come at retirement age. When you withdraw your contributions and earnings from a Roth 401(k) account, you will pay nothing in taxes, because you will have already been paying during contributions!
The choice between a Roth or Traditional 401(k) lies in whether people expect to be in a higher income tax bracket at retirement age. If they do, then they will often elect a Roth 401(k). If they expect to be at a high income tax bracket now than they will be upon retirement, a Traditional 401(k) account is appealing. For reference, many young people have a preference for Roth accounts (401(k) or IRA) because they expect to increase their earnings—and thus their income tax bracket—as they age.
What happens to my 401(k) if I change jobs?
You have four main options when dealing with your 401(k) with a job change:
1. Withdraw the money
While tempting, electing this option can be a bad idea. Doing this will trigger early withdrawal fees at 10% and will add your total withdrawals into your taxable income.
2. Roll it over into an IRA
Your employer and brokerage will often give you a grace period to roll over your 401(k) into an IRA fee-free. Doing this will allow you to avoid taxes and maintain your funds in a tax-advantaged account.
3. Leave it with your former employer
This is dependent on whether or not your employer allows you to do this. But if they do, and you are satisfied with the investment choices and management of the account, then this could be a good option.
4. Move it to your new employer
This is a good choice if you want to move the money out of your former employer, but don’t want the responsibility of managing it on your own in an IRA. Check with your new employer on whether this is available.
The retirement savings account you choose is personal; everyone’s situation is unique, so what may make sense for one person in your age group, for example, might not make sense for you. As you progress in this part of your research process, know that you are taking great steps towards your wealth-building journey.