Put simply, a 401(k) plan is an employer-sponsored retirement savings plan.
Through these plans, you can save money towards retirement on a tax-deferred basis, which means you don’t pay federal or state income taxes on your savings or their investment earnings, until you withdraw the money at retirement.
Since most people’s taxable income is lower at retirement than during employment, they end up paying less in taxes on this type of savings — which makes 401(k) plans one of the most valuable savings tools out there.
How do 401(k) plans work?
With a regular 401(k) plan, money is deducted from your paycheck before taxes are taken out, which in turn lowers your taxable income and, therefore, lowers your taxes.
The money is then placed into your 401(k). With the 401(k), you decide how your money is invested.
Most plans offer a variety of mutual funds, which are made up of stocks, bonds, and money market investments. Some financial advisors recommend spreading out your money within and across different asset classes for diversity.
Free money?
Additionally, many employers offer a company match, which means that your company will match your contribution, up to a certain percentage or sometimes up to a certain dollar amount.
Let’s say your employer will match whatever percentage you put towards your 401(k).
Say you decide to contribute 5% of your salary to your 401k as your employer will match that 5%. If you make $60,000 a year, that’s 5% before taxes, which is $3,000.
Your employer contributes the same amount. That’s why it’s important to contribute at least enough to take advantage of your company’s match in full. Free money is always good, right?
However, keep in mind that 401(k) plans also come with restrictions. In many cases, you can’t tap into your company’s contributions immediately after you’re hired.
You must wait a certain amount of time — a period called vesting. The IRS also limits the amount of money you can put into your 401(k) savings, depending on your age and salary.
There are also rules on when you can withdraw your money, and you can face penalties for pulling out funds before you reach retirement age.
Benefits of a 401(k) plan
A 401k is designed to help you save for your retirement years, so you’ll be financially stable in those years where you’re no longer working.
The amount you contribute to your 401(k) is exempt from federal income tax, so it lowers your taxable income.
You are in control; you can contribute as much or as little as you want to your account (subject to plan and IRS limits). Plus, you have the flexibility to change your contribution levels at any time (subject to plan limits) dependent on your situation.
Your 401(k) earnings accrue on a tax deferred basis. And you have investment customization and flexibility — again, you’re in control of where you want your money invested.
What happens if you change jobs?
If you’re moving from one job to another, there are several different things you can do with your 401(k):
- Leave your assets in your old employer’s plan.
- Complete a rollover to your new 401k employer.
- Rollover your 401k to an Individual Retirement Account (IRA).
- Cash out the proceeds and pay taxes and the 10% penalty fee if you’re under 59 ½ years old or 55 years old in some cases.
You are the only person who has your own vested interest fully at heart, so it is up to you to ensure you know what your plan is all about and how to take full advantage of it.
The best thing you can do to ensure you are on the right path is to hire a certified financial planner (CFP) to have them put together a custom financial plan based on your current assets, liabilities, as well as needs, wants, and wishes.
He or she will have you fill out a detailed questionnaire so that they can better understand how you live today and how you want to live in the future.
