Updated: Dec 3, 2021
A 401(k) retirement plan is an employer-sponsored savings option for employees. It allows workers to invest a portion of their paycheck before the amount earned is subject to taxes.
When you place money into the 401(k) retirement plan, then there are no tax responsibilities on the amount until you withdraw funds from the account.
The name of this retirement option comes from the part of the IRS tax code that governs this option. It began in the 1980s as a way for workers to supplement what they received in a pension. Over time, as the cost of running pensioner accounts rose, the 401(k) became the prominent method of creating a comfortable retirement.
How Does a 401(k) Plan Work?
Even though a 401(k) retirement plan receives employer sponsorship, you stay in control of the investment choices made with those funds.
Most plans provide you with different mutual funds that feature money market investments, stocks, or bonds. There are varying levels of risk that you can assume with these choices as well. One of the most popular options is to use target-date funds because the strategy becomes more conservative as you approach your retirement date.
Having a 401(k) can help you to save quite a bit for your retirement if you stick with this investment option. There are also several caveats and restrictions of which you will want to be aware to understand the entire process of saving.
How Should I Contribute to a 401(k) Retirement Plan?
A 401(k) retirement plan helps you to save for your retirement. That means you should contribute as much as you can to it while being mindful of your current expenses.
You need to keep enough funds to pay your rent or mortgage, have food, and pay down debts you might carry each month. Then you should keep an amount for entertainment purposes, vacations, and other activities that make life enjoyable.
Most employers offer a matching amount, so try to contribute enough to take advantage of this full benefit. If you do not, then you’re leaving free money on the table.
If your employer offers a 2% match and you earn $50,000 per year, then the total contribution to your 401(k) would be $1,000. Then you’d receive another $1,000 in a benefit. You can put more into your retirement if you wish, but your company would not match anything further.
Most businesses allow you to enroll in their 401(k) retirement plan right away. Some employers might make new workers wait for up to a year to join.
401(k) Restrictions to Consider Before Investing
Most employers hire an administrator to oversee all of the 401(k) plans. You’ll receive updates from this organization about your account and its overall performance. These firms will help you with your paperwork, facilitate investment requests, and maintain the integrity of your account.
Employers typically match a small portion of your salary as a benefit when signing up for a 401(k) retirement plan. Most matches are between 1% to 4%, although they can be significantly higher in some professions. There may be a vesting period that acts as an insurance policy against having workers leaving the company. You might need to wait between 6-36 months (and sometimes longer) to have access to the extra funds.
The maximum contribution amount to a 401(k) in 2019 is $19,000 for the entire year. That figure covers all elective salary deferrals and after-tax contributions.
Employers can contribute as well, but there is a $56,000 limit on combined contributions.
Anyone age 50 or over qualifies for what is called a “catch-up contribution” to their 401(k) retirement plan too. This stipulation allows you to contribute an additional $6,000 per year to the account.
These limits are also in place for most 457 and 403(b) retirement plans, along with the Thrift Savings Plan from the federal government.
What Happens If My Company Goes Out of Business?
If the financial situation of your employer is questionable, then your 401(k) receives protection. The funds in that account are off-limits if your employer goes under. The retirement plan will terminate, giving you the option to roll the money over into a different account, such as a traditional IRA.
You can also access the funds in your 401(k) at any time. Hardship withdrawals and loans are permissible if you run into financial trouble. If you need the money and don’t want one of those options, then there is a 10% early withdrawal penalty and the funds qualify for state and federal income taxes.
If the traditional contribution method doesn’t feel appropriate for your finances, then a Roth 401(k) is an alternative to consider. Because your contributions are made with after-tax money, you’ll have free access to the account if you’ve held it for at least five years. There are no taxes paid upon withdrawal either.