Saving With a 401(k)

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A 401(k) savings plan is one of the most common ways to prepare for retirement. According to the Investment Company Institute, 401(k) funds held around $6.2 trillion at the end of 2019. That accounts for almost 20% of all saved retirement funds in the country. Find out more about these popular plans and how you can use one to save for your future.

What Is a 401(k) Plan?

A 401(k) plan is a defined-contribution retirement plan that comes with tax advantages. Okay—that’s a lot of financial jargon, but what it boils down to is this:

• You contribute to your 401(k).
• Your employer may also contribute to your savings via defined employer matching.
• The money you contribute is pretax, which means your contributions reduce your taxable income.
• You can only contribute so much each year untaxed.
• Once money goes into the 401(k), there are tax rules that govern how you pay taxes and/or penalties if you withdraw money.

Once you contribute to a 401(k) plan, those funds are invested and managed for you. The amount you put in earns interest over time on those investments, and the goal is to end up with much more than you put in once you get to retirement.

How Are 401(k) Plans Taxed?

You don’t pay taxes on any income that you put into a 401(k). The funds are considered tax deferred, which means you will pay taxes on them later.

If you withdraw the money during retirement, you pay regular retirement income taxes on it. How much you pay depends on factors such as tax rates at the time and how much total retirement income you earn.

If you withdraw money early—before you reach retirement age—you also pay taxes on it. You might also pay a 10% early withdrawal fee.

401(k) Contributions

Contributions refer to the money you put into your 401(k). They also refer to the money your employer adds to your fund.

When Should You Start Contributing?

Prevailing wisdom when it comes to retirement savings is that it’s never too early to start contributing to 401(k) or other retirement savings account. That’s because your investments earn money over time, so the longer your funds are invested, the more they can earn. Starting retirement planning as early as your twenties can mean you end up with much more money in retirement without actually paying more into your 401(k) yourself.

How Much Should You Contribute?

Obviously, you need to contribute in a way that you can afford—you don’t want to starve yourself today so you can eat tomorrow. Here are some general rules for determining how much you should contribute to a 401(k):

• More is better. When saving, more is typically better as long as you can afford it. Take an honest look at your personal budget and consider cutting frivolous expenses where you can to save for your future.
• Consider company matching. One of the benefits of a 401(k) is that many companies match your contributions up to a certain percent of your salary. Find out what those limits are, and whenever possible, contribute up to that amount to maximize your savings. For example, if the employer will match contributions up to 3% of your salary, set your contributions to 3% to get a 6% total contribution.
• Know the contribution limits for each year. The IRS sets contribution limits for 401(k) plans every year. You can only contribute up to that amount and receive the tax benefits. In 2020, the limit is $19,500.

What Are Catch-Up Contributions?

Someone who is age 50 or older can exceed the IRS contribution limits for retirement savings by a certain amount each year and still get the tax benefits. This is allowed so that people who are close to retirement can “catch up” their retirement savings to appropriate levels if desired. The catch-up limit for 2020 is $6,500 annually.

Fees and Penalties

Your 401(k) is not free. Depending on how you use the funds, it comes with a variety of fees and potential penalties.

Early Withdrawals

The biggest expense related to 401(k) savings is associated with early withdrawal. This occurs when you take money out of your retirement fund before you reach retirement age, which is typically considered to be 65. However, some plans have earlier retirement ages.

In general, you pay a 10% penalty plus applicable income taxes on early withdrawals. There are some exceptions, such as someone being totally disabled or paying for qualified education expenses. In these and other specific cases, the 10% penalty might be waived.

Required Minimum Distributions

Once you reach a certain age, you have to receive a required minimum distribution (RMD) from your retirement plans each year. RMDs begin when you’re 72 if you’re born after July 1, 1949. For those born earlier than that date, RBDs began at age 70.5.

The amount of your RMD depends on how much you have in your retirement savings, among other factors. You must report your distributions as income on federal tax forms and pay any applicable income taxes on them. And, if you don’t take your RMD, you may have to pay an excise tax of 50% on the amount that you didn’t take.

Expense Ratios

Most 401(k) holders pay expense ratios. These are small fees taken by the management company in payment for services provided as they manage your retirement investments.

According to a TD Ameritrade study, the average expense ratio fees are around 0.45% of the retirement fund balance. That means if you have $500,000 in 401(k) savings, you pay roughly $2,250 annually in expense ratio fees. Many people don’t realize they pay such fees because it’s taken out of their 401(k) earnings, so it’s important to look at your statements regularly.

401(k) Loans

In some cases, you might find that you need your 401(k) funds to help with a current expense. Depending on your employer’s policies and those of your 401(k) account, you may be able to take out a loan against your 401(k).

Once you take out the loan, you make monthly payments on it. These are usually deducted from your paycheck and include interest. The total monthly payment is paid into your personal retirement fund.

Often, 401(k) loans are limited to certain types of expenses. Reasons for taking such a loan include covering the costs of buying a new home or education expenses.

One disadvantage of these loans is that it means those funds are no longer earning interest as an investment. Typically, the amount of interest you pay on the loan doesn’t make up for this fact, so loans can reduce how much you have when you get to retirement—which is less than ideal.

Preparing for Retirement

It’s never too early to start preparing for retirement, and a 401(k) savings plan is just one way to do so. Learn more about retirement planning and what you can do to save for your future today.