A 401(k) is an employer-sponsored retirement plan with some up-front tax benefits. The money you contribute to a 401(k) is tax-deferred, so income you put toward your 401(k) is not taxed as income as long as it is within the contribution limits
How does a 401(k) work?
If your employer offers a plan, you typically sign up through the human resources (HR) department first. Then you determine a contribution amount from each paycheck which is then allocated to your chosen investments - employers typically offer a few investment options from which to choose.
How does 401(k) matching work?
Check with your employee benefits or HR department on the exact details of when you can begin participating and the amount of any matching offered. Usually, these matches are predefined. For example, your employee might say they will match $.50 for every dollar you contribute up to the first 5 percent. The employer match is a nice benefit that allows you to have extra money invested for your retirement.
Something else to consider is vesting. This is the amount of the total 401(k) that you own. Anything you contribute to your 401(k) is 100 percent owned by you. Many employer matching plans have a vesting schedule. For example, for the first five years of employment, the company match is 20 percent vested and after that the match is 100 percent vested.
That means for each of the first five years, you would own 100 percent of your contributions and 20 percent of your employer's and after that, you would own 100 percent of both.
What are the 401(k) 2019 limits?
The Internal Revenue Service (IRS) puts a limit, also called a cap, on how much you can contribute to your 401(k) each year. For 2019, the limit is $19,000.
There are a few ways to increase those limits.
If you're age 50 and over, you can use "catch up contributions" to add an additional $6,000 in 2019. Your employer can currently contribute an additional annual maximum of $37,000 for a combined "all sources" contribution of $56,000 ($62,000 for those age 50 or older).
Contribution rates often tie to inflation - the increase in prices of services and goods over time. When inflation rises, you get less bang for your buck. So it's important to pay attention and adjust your contributions accordingly. Your financial professional can work with you to develop a strategy that takes inflation into account and help minimize the impact.
How will 401(k) withdrawals be taxed?
You will pay taxes on withdrawals from your 401(k) account. Withdrawals are taxed as ordinary income.
In order to avoid an additional 10 percent early withdrawal penalty, you'll want to wait until you are age 59 1/2 before you start withdrawing money from your account. This is also called taking distributions, and it applies even if you've retired early. You can wait until you are 72 before you must take annual required minimum distributions (RMD), otherwise you'll get hit with a substantial tax penalty.
How much can I borrow against my 401(k)?
It may not be a good idea, but you can borrow from your 401(k) tax-free. The loan can be the lesser of $50,000 or 50 percent of your total vested amount.
Keep in mind, you'll have to repay any money you take from your 401(k) - usually within five years, in most cases, via a set payment plan. You will have to pay penalties if you don't do this or if you miss payments. The same is true if you end up suddenly unemployed. It's up to the plan provider if you can continue your loan payments or have until the tax-filing deadline for the year of the withdrawal to repay the loan. Otherwise, the IRS will consider money you've borrowed as a distribution and you will have to pay all the taxes and penalties that come with it come tax day.
If you're considering borrowing, realize that even though the money you put into your 401(k) is tax-deferred, the money you use to pay your loan back is post-tax. That means you're not only paying yourself back at an interest rate but you're also missing the opportunity for that money to potentially grow while it's not in your account.
Remember, your 401(k) is for your retirement, and withdrawing or borrowing from it early may jeopardize your financial future.
What happens to my 401(k) when I leave my employer?
If you leave your job you have some options for what to do with your 401(k):
- Leave the money where it is
- Roll it over to another qualified plan from your new employer
- Roll it over to a new individual retirement account (IRA) - another way to save for retirement
You can also cash it out, but remember: If you're under age 59 1/2, you'll have to pay taxes and a penalty.
Can I get a 401(k) on my own?
If you're self-employed, you can set up what's called a solo 401(k). It works similar to an employer-sponsored plan. However, one of the big exceptions is that it has a much higher individual contribution limit. For 2019, the contribution limit for a solo 401(k) is $56,000 with an additional $6,000 for those 50 and older.
Have other questions about your 401(k)? Read more about 401(k) plans and retirement planning.