To make sure you're prepared, we've outlined some important information about these retirement plans and answer your most common 401(k) FAQs.
What is a 401(k)?A 401(k) is an employer-sponsored retirement plan that has some tax advantages. 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?Many employers offer 401(k) plans as part of a benefits package. If you are a sole proprietor or the only owner of a business, you can also contribute to an individual 401(k).
Once you sign up for your 401(k) — usually through your company's HR department — you'll decide how much you want to contribute out of each paycheck. That amount is allocated to your chosen investments.
How does 401(k) matching work?Some companies offer employer-matching to your 401(k) contributions. That means your employer will match every dollar you put into your 401(k), usually up to a set percentage or amount.
For example, your employer might match 50% of every dollar you contribute up to 3% of your salary. In that case, your company is essentially giving you free money. Many experts recommend contributing at least the amount required to receive a full employer match.
What is vesting?Vesting is the amount of the total 401(k) that you own. Anything you contribute to your account is fully owned by you. However, companies will set a vesting schedule that covers the amount they contributed to your 401(k).
A common example is for the first five years of employment, the company match is 20% percent vested per year and, after the fifth year, the match is 100% vested.
That means for each of the first five years, you own all of your contributions and 20% of your employers. After the fifth year, you own 100% of both.
What are the 401(k) 2021 limits?The Internal Revenue Service puts a limit — also called a cap — on how much you can contribute to your 401(k) each year.
For 2021, the limit is $19,500 for employer-sponsored 401(k)s. The limit for one participant 401(k) plans is $57,000. This limit is higher because a single-owner business can contribute as an individual and as the business.
If you're age 50 and over, you can use "catch-up contributions" to add an additional $6,500 in 2021.
How will 401(k) withdrawals be taxed?You will pay taxes on withdrawals from your 401(k) account. Withdrawals are taxed as ordinary income.
If you withdraw funds from your account before you are age 59 1/2, it will be taxed and an additional 10% early withdrawal penalty will apply. Once you hit age 72, you will need to take annual required minimum distributions — otherwise, you'll get hit with a substantial tax penalty.
Can I borrow against my 401(k)?The 401(k) is a retirement plan, which means that you are discouraged from taking withdrawals out of the plan before you reach age 59 1/2. However, there might be times where you have no other choice.
If that's the case, you can borrow from your 401(k) tax-free. Your loan limit is the lesser of $50,000 or 50% of your vested account balance, as long as that balance is over $10,000.
You will need to repay any money you borrow within five years. If you can't repay within that time frame, or if you miss a month in your payment plan, you'll also have to pay penalties.
Also, keep in mind, 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 retirement — 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, which is another way to save for retirement
- You can also cash it out, but don't forget: If you're under age 59 1/2, you'll have to pay taxes and a penalty.
Can I withdraw from my 401(k) if I leave my job?If you leave your job, you can start taking penalty-free withdrawals from your 401(k) as soon as you turn 55. If you keep working past this age, you can start taking penalty-free withdrawals once you turn 59½. All distributions from traditional 401(k) plans are taxed as ordinary income.
When you take a retirement withdrawal, you'll need to pay income tax on that amount.
Have other questions about your 401(k)? Read more about 401(k) plans and retirement planning.