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What is a 401(k)? (The Basics You Need to Know)

Reading time: 5 Minutes

July 23rd, 2020

It's never too early to begin planning for retirement. In addition to savings accounts, investments and personal assets (for example, if you own a home), a 401(k) retirement savings plan can help provide you with a solid financial cushion for later in life.

Unsure about how 401(k)s work, or how to get one and manage it? Don't worry, here's a quick overview of the basics:

What is a 401(k)?

A 401(k) is a retirement savings plan that automatically sets aside part of your paycheck to invest in stocks, bonds, mutual funds or other assets. It can be a great way to save up money because not only is it possible to earn dividends on the money you put away, so that your nest egg ends up much larger than the initial amount you put in, but you also do not have to pay income tax on any money that you deposit into a 401(k).

Named after subsection 401(k) of the IRS tax code, these specific types of accounts are the most common type of retirement plans in the United States sponsored by private employers. (Employees in the public sector often use 457 plans, while employees in the nonprofit sector use 403(b) plans.)

401(k) plans became popular in the 1980s as a way to supplement or replace pension plans, which are funds managed and paid out by employers over the course of one's retirement. Some government jobs and unions still offer pensions, but, due to the increasing cost of running these types of plans, many employers replaced their pensions with 401(k)s.

How does a 401(k) work?

For most employees, income taxes are withheld on money received. However, a 401(k) plan allows individuals to avoid paying income taxes on any money deposited into the plan in a given year. Money is allowed to grow, tax-deferred, inside your plan. You'll only need to pay tax on any amounts withdrawn in retirement.

For example, let's say you earn $50,000 a year and choose to contribute 5 percent of your salary ($2,500 a year) to your 401(k) plan. If you receive paychecks twice a month, then $104.17 will be taken out of each paycheck before taxes, and added to your 401(k). At the end of the year, your reported earned income on your tax return will be $47,500 instead of $100,000. If you are in the 22% income tax bracket, the amount that went into your 401(k) will result in $550 less in federal taxes paid. You save $2,500 towards retirement, but it only costs $1,950.

The funds you deposit into your 401(k) go into an investment portfolio overseen by a fund manager who invests the money into a mixture of stocks and bonds. Depending on the portfolio you select, these investments may be more aggressive (bigger risk but bigger reward) or more conservative, with more modest gains but with less risk for volatility in the market.

What are my contribution limits?

There are two types of contribution limits to your 401(k): on the maximum amount of salary deferral contributions per year, and the amount of total contributions per year—which includes contributions from both you as well as your employer. In 2020, individuals ages 49 or younger can contribute up to $19,500 of their annual wages, while those ages 50 or older can contribute up to $26,500. The maximum total contribution limit is $57,000 for people age 49 or younger, or $63,500 for ages 50 and up.

What role does my employer play in my 401(k)?

Some companies may contribute additional money to your 401(k). There are three main types of employer contributions

  • matching, where your company matches your contributions dollar-for-dollar up to a certain percentage
  • non-elective, which means your company will contribute a set percentage into everyone's 401(k), regardless of whether employees are putting their own money in
  • profit sharing, where money is contributed according to how much profit the company has earned in a given year

Generally speaking, it's wise to take advantage of any 401(k) matching program that your company offers. However much it is, the match is essentially free money that can be added to your retirement savings.

Keep in mind that matching contributions made by some employers may be subject to a vesting schedule, which means that money is only yours if you remain employed at that company for a set amount of time.

If you leave your company or change jobs, you have a few options for your 401(k): You can usually leave the money in your former employer's plan, but you'll be unable to further contribute to it and, if your previous company gets bought or switches 401(k) providers, it can be difficult to keep track of account numbers and login credentials. Another option is to roll over your 401(k) balance to your new employer's plan, which may offer equal (or improved) investment choices and potentially lower fees. Your third option is to roll your 401(k) into an individual retirement account (IRA), which operates similarly to a 401(k), except it isn't tied to an employer.

How do I avoid potential fees and penalties?

401(k) plans come with a lot of benefits, but there are also rules that restrict what you can do with your money. Disregard those rules, and you could be on the hook for fees and penalties that may erase the gains you've accumulated.

Don't withdraw early. A 401(k) is a retirement plan, not a savings account. If you take out money before age 59 and a half, you'll pay a 10 percent early withdrawal penalty on the amount your withdraw, on top of income tax. (Although there are exceptions; if you leave or lose your job at age 55 or older, you won't have to pay the 10 percent penalty on 401(k) withdrawals related to that job.)

Additionally, you'll receive a fee disclosure statement each year as part of your 401(k). This document lists key info about your plan, including any additional fees associated with the funds or possible charges that might be incurred depending on your actions.

After age 70 and a half, you'll be required to start withdrawing money from your 401(k), unless you're still working for a company that you do not have an ownership stake in. If you miss one of these required minimum distributions, the penalty is 50 percent of the amount that should have been withdrawn; again, on top of regular income tax. For example, an individual in the 22 percent tax bracket who skips a 401(k) distribution of $5,000 would have to pay $3,600 in penalties and taxes.

Who gets the money if I pass away?

When you sign up for your 401(k), you will be asked to select a beneficiary who would receive the total funds in case of your death. If you are married, federal law automatically establishes your spouse as beneficiary, unless they sign a waiver. If you are single, the account goes to whomever you name as beneficiary. Keep in mind that if you remarry, your new spouse will automatically become beneficiary to your 401(k)—again, unless they sign a waiver.

401(k) retirement plans are not insured by the FDIC, are not deposits or obligations of the bank or its affiliates, are not guaranteed by the bank or its affiliates, and are subject to investment risk, including possible loss of principal.

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