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For many Americans, a 401(k) is the key to their retirement plan. Still, many workers don’t understand how these plans work. To make sure you’re prepared, we’ve outlined the most important information about 401(k) plans.
To invest in a 401(k), you need to work at a company that offers one. You can’t open one up a plan on your own. Once you’re in a 401(k), your company will tell you what percentage of your salary you can put away per year into the company plan. Some companies also match your contributions.
For example, a 401(k) plan might let you invest a percentage of your salary each year and your company would match 50 cents for every dollar you add to your account up to three percent of your salary. The company match is free money, and it’s usually a good idea to invest the full percentage of the match.
Your company will tell you the maximum percentage of your salary you can add to the 401(k) each year. However, the government also limits how much you can invest in a 401(k). As of 2013, you can add up to $17,500 a year to your account if you are younger than 50 and up to $23,000 if you are 50 or older. Each year, you can contribute the lesser of the plan’s maximum percentage or the government limits.
The money in your account will be a mix of the contributions from your pretax earnings and your company’s matching contributions, assuming your company offers that benefit. Your pretax earnings come out of your paycheck and will remain your money even if leave your job. The company match is a bit less certain. Many companies have restrictions on when the matching contributions actually become yours. This is called vesting. You usually need to stay with the company for a minimum number of years or else you could lose some or all of your matching contributions.
The money added to your 401(k) can be deducted from your taxes. This helps you tackle two important financial goals: saving for the future while also bringing down your current tax bill.
Once your money is in a 401(k), you’ll be investing it in a variety of stocks, bonds, mutual funds and other investments. Typically, when you invest, you need to pay taxes on your investment earnings right away. Not with the 401(k). As long as you keep your savings in this account, you can put off paying taxes on these gains until retirement.
The 401(k) is a retirement plan so you are supposed to keep your money in the plan until you reach a certain age. If you leave your job, you can start taking retirement withdrawals from your 401(k) as soon as you turn 55. If you keep working past this age, you can start taking retirement withdrawals once you turn 59½.
When you take a retirement withdrawal, you’ll need to pay income tax on that amount.
Taking money out of your 401(k) before retirement can be difficult. First, your company plan needs to allow early withdrawals. Then, it gets expensive. The IRS charges an extra 10 percent penalty on top of income taxes on early 401(k) withdrawals. The penalty can be avoided in a few situations, such as paying for excess medical bills or college tuition.
You might also be able to take money out as a loan. When you take a 401(k) loan, you won’t owe taxes or a penalty provided you pay the money back into your plan with interest. Once again, whether you can take a loan depends on your company’s plan rules.
If you leave the company offering the 401(k), you won’t be able to add any more money to its plan. In this situation, it usually makes sense to take your retirement savings out the door with you, through an account rollover. When you roll over your old 401(k), you transfer the account straight into another retirement plan, like an IRA or your new job’s 401(k). You won’t owe any taxes on the move and can get right back to work investing as normal.
Managing a 401(k) takes some work but for most people, it’s an important piece of retirement planning. If you have questions, about this financial tool, consult a financial advisor.
Protective Life Insurance Company is not a 401(k) plan manager, does not recommend or endorse any particular investment option and does not provide investment, legal or tax advice. When considering your options with your agent and financial planner, you will also want to consult your attorney or tax advisor about your specific needs.