Saving money for retirement is one of the major financial milestones that everyone should carefully plan for in their lifetime. 401(k) plans are one type of savings plan that may help you to achieve your goals through saving, investing, and earning interest.
How does a 401(k) work?
401(k) plans are one of the most used methods to save for retirement. 401(k)s allow employees and their employer to contribute money towards the employee's retirement savings. The employee makes decisions regarding how to invest their money to maximize earnings.
- Open a 401(k) through your employer. The employer, as plan sponsor, hires a plan administrator, who is responsible for managing your funds and investments.
- You and your employer make contributions. As the employee, you may designate a set percentage of your paycheck or a set dollar amount to contribute automatically. Your employer may choose to match your contributions up to a certain percentage or contribute a set dollar amount.
- Your funds are invested, and you receive an annual rate of return. You decide how the money in your 401(k) should be invested. You may decide to select an investment fund based on the year you plan to retire, or you may choose an investment portfolio with higher or lower risk. You receive an annual rate of return on your investments, which may be greater than the average savings account interest rate.
- Your money grows over time. 401(k)s are designed to help maximize long-term savings through investment gains and compound interest. In order to encourage people to leave their money invested in their 401(k), the IRS generally imposes an early withdrawal penalty on any withdrawals made before the age of 59 1/2.
The earlier you start saving, the better. The number of years until retirement age matters. Individuals who contribute at a younger age may take advantage of additional contributions, additional employer matches, and compounding interest to watch their funds potentially grow over time.
Why use a 401(k)?
There are a lot of great reasons to use a 401(k) plan as one strategy for retirement savings.
- Employer matching: Some employers offer 401(k) matching, which is when your employer will match either your full contribution or up to a certain percentage of your gross income. If your employer offers this, you may be able to increase your retirement savings simply by taking advantage of this benefit.
- Compound interest: By depositing your money into an interest-bearing plan, you earn a set percentage of your overall balance in interest each year. Over the years, that overall balance increases based on the interest you earn and investment gains, which means you earn money on earned money.
- Vesting: Contributions that you make to your account are not always 100% vested, meaning there’s a waiting period or employment time required before the funds are owned entirely by the plan holder (the employee). It may be a set number of months or years before you are fully vested in your employer contributions and may take them with you if you leave your job.
- Tax benefits: The funds you contribute, and the interest or investment gains earned are not subject to taxes until they are withdrawn (or distributed). This is helpful because you end up lowering your annual taxable income each year that you contribute to your 401(k). Most individuals find themselves in a lower tax bracket by the time they reach retirement age, which could allow you to ultimately pay a lower tax rate upon withdrawal.
What are my 401(k) choices?
There are several types of 401(k) plans, each with slightly different rules and requirements. Ultimately, you will only be able to choose from the types of plans offered by your employer’s selected provider, but two important factors to consider for each type of plan are contributions and vesting.
- Contributions: Employees may make pre-tax contributions. This means the money is not considered part of your taxable income the year it is contributed. Employers may make contributions on behalf of participating employees.
- Vesting: Some plans may be subject to a vesting schedule, meaning employees must work a specified amount of time before having the rights to any employer contributions.
- Contributions: Employers may contribute into an employee’s plan even if the employee has not contributed.
- Vesting: Must provide for employer contributions that are fully vested when made, meaning employees do not have to work a specified amount of time before gaining contributions put in by their employer.
- Only available to small business employers with less than 100 employees who receive at least $5,000 per year from the employer.
- Contributions: Employees who are eligible to participate in a SIMPLE 401(k) plan may not receive any contributions or benefit accruals under any other plans of the employer.
- Vesting: Employers are required to make employee contributions that are fully vested.
How much should I contribute?
The amount you should contribute to your 401(k) is dependent on your specific situation and retirement savings goals. However, there are two important considerations to keep in mind — employer matches and contribution limits.
- Employer matching: If your employer offers 401(k) matching, many experts suggest that you contribute at least the maximum percentage that your employer will match. For example, if they will match up to 6%, you should contribute 6% to take full advantage of this benefit. After all, your employer is essentially giving you free money toward your retirement.
- Contribution limits: Each year, the IRS sets contribution limits that apply to 401(k)s. These limits apply to how much both you and your employer may contribute. These limits are in place because the money you contribute to your 401(k) is tax-deductible on federal and most state tax returns for the year the contribution is made. Check with your employer on how much you and your employer can contribute for the year.
When can I withdraw money from my 401(k)?
One of the most important restrictions to understand about 401(k)s is that you cannot withdraw money penalty-free from your plan without meeting certain age requirements.
If you are...
- Under the age of 59½: You will pay taxes and a 10% additional penalty on the distribution, with exceptions. There are some special circumstances when funds can be withdrawn penalty-free, such as for first-time homebuyer expenses, qualified higher education expenses, expenses for extreme financial needs, disability, and certain levels of unreimbursed medical expenses.
- 59½ or older and still employed: You may withdraw funds penalty-free from plans sponsored by past employers but withdrawing funds from current employers may be limited by their plan’s policies.
- 59½ or older and retired: You may withdraw funds penalty-free.
- Over the age 72: You are required to take at least minimum distributions from your 401(k) funds.
Remember, since your typical 401(k) contributions are tax-free, you are subject to paying taxes on all distributions regardless of the age you decide to withdraw the funds. What you risk by withdrawing early is paying an additional penalty fee on top of ordinary tax rates.
How will my funds be invested?
Once you have contributed money to a 401(k) you will designate how your funds will be invested. Some investments carry more risk than others. Understanding your personal level of risk-tolerance is key to diversifying your investment choices to manage risk. Some include mutual funds, company stock, bonds, variable annuities, and index funds. Check with your employer on your options.
An option that your plan may offer is a target-date retirement fund, which is a portfolio made up of different types of investments all set to mature by a specific year. Your fund manager oversees the portfolio and communicates the perceived risk-level to you based on the types of investments selected.
The information in this article was obtained from various sources not associated with Adirondack Bank. While we believe it to be reliable and accurate, we do not warrant the accuracy or reliability of the information. Adirondack Bank is not responsible for, and does not endorse or approve, either implicitly or explicitly, the information provided or the content of any third-party sites that might be hyperlinked from this page. The information is not intended to replace manuals, instructions or information provided by a manufacturer or the advice of a qualified professional, or to affect coverage under any applicable insurance policy. These suggestions are not a complete list of every loss control measure. Adirondack Bank makes no guarantees of results from use of this information.
Article written by EVERFI