What is a 401(k)? What you need to know about this investment vehicle for retirement

Withdrawal account statement
When it comes to contributing to a 401(k), it’s important to do your research first.

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If you work for a private company, one of the easiest ways to save for retirement is a company-sponsored 401(k) plan.

A traditional 401(k)⁠—named after a subsection of the US tax code⁠—is a retirement plan offered by many employers. Employees choose to have a pre-tax percentage of their income withdrawn and put into the account. Employers typically offer a selection of stocks, bonds, cash, mutual funds, and other investments.

Here’s what you need to know about the Retirement Savings Account.

How much of my income should I put in my 401(k)?

Most financial experts recommend contributing 10-15% of your income, including employer contributions, called “matching” funds, to your 401(k). Many banks or financial websites offer easy-to-use retirement calculators, as does the Department of Labor.

Many employers offer what is called a matching contribution as a benefit, but the percentages vary. Suppose your employer offers 401(k) contributions at 50% “matching”. This means that if you contribute $10,000 per year, your employer contribution will be $5,000, so you will end up with $15,000.

How is a 401(k) plan taxed?

There are two main types of 401(k) plans: traditional and Roth.

  1. Traditional: You pay no federal income tax on contributions to a traditional 401(k) plan until you withdraw from the account. This means that investments grow tax-free.

  2. Roth: Contributions to a Roth 401(k) are made after tax. When you withdraw, the funds will not be taxed because you contributed with after-tax income.

An Individual Retirement Account (IRA) is opened by an individual, usually through an investment company, bank, insurance company, or broker. A 401(k) is opened and managed by an employer. According to IRS rules, contribution limits are higher for a 401(k) than for an IRA.

The limit for employer-sponsored 401(k) plans in 2022 is $20,500 after the IRS raised the limit by $1,000 last year. That’s way more than the $6,000 maximum for traditional and Roth IRAs.

Can you withdraw from your 401(k) account without penalty?

In general, withdrawing money from a retirement plan before reaching the age of 59.5 carries a penalty. The IRS calls this move an early — or “premature” — distribution. You will end up paying a 10% tax on the early withdrawal unless you qualify for an exception.

Can you take out a loan on your 401(k) plan?

If your plan allows it, you can borrow up to $50,000 or half of your vested balance. Most plans give borrowers up to five years to repay the loan – with interest.

Be careful though: if you lose your job and don’t repay by that year’s tax deadline, the IRS considers your loan a withdrawal. This means that if you are under 59.5 you may have to pay the 10% early withdrawal tax penalty.

What happens to my 401(k) if I change jobs?

Most payments to your 401(k) plan can be “carried over” to another 401(k) plan or IRA within 60 days. You can ask your financial institution or plan administrators to transfer the payment directly. Generally, you won’t pay tax on the funds until you opt out of the new plan.

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