A 401(k) plan is a workplace retirement savings account. 401(k) accounts get their odd name from the section of the tax code that created and governs them. Workers and employers can both make deposits to the account until they hit annual contribution limits. The federal government provides tax breaks to workers who save in a 401(k) plan. The employee may choose among a limited menu of investment options selected by the company or plan sponsor. However, money invested in a 401(k) account is meant to be used for retirement, and a penalty is applied to early withdrawals.
Here is what you need to know about your 401(k) plan:
— The 401(k) contribution limits.
— The 401(k) match amount.
— How to decide between a traditional or Roth 401(k).
— How to take 401(k) withdrawals.
— Your 401(k) loan options.
— How to roll over a 401(k).
401(k) Contribution Limits
The contribution limit for 401(k) plans is $19,500 in 2020 and is adjusted for inflation each year. Employees age 50 and older can make catch-up contributions of up to an additional $6,500 for a maximum possible contribution of $26,000 in 2020. Contributing to a 401(k) plan via payroll deduction makes it easy and convenient to regularly save for retirement, and since the money never hits your checking account, there’s less temptation to spend it.
“Even if you’re only contributing $25 per paycheck toward a retirement account, that’s better than $0. It will add up over time,” says Courtney Ranstrom, a certified financial planner for Trailhead Planners in Portland, Oregon. “Plus, it will help you build good savings habits that you can continue to use as your ability to save increases.”
Some employers automatically enroll workers in the 401(k) plan and automatically increase the savings rate over time unless employees opt out.
Companies can make contributions to 401(k) plans on behalf of employees, often as a 401(k) match. Find out how much you need to save to get any employer contributions your company provides. The most common 401(k) match formula is 50 cents per dollar saved up to 6% of pay, but employers differ considerably in the amount they contribute to employee 401(k) plans.
“Making the effort to at least get the benefit of that match is often worth it,” says David Wattenbarger, a certified financial planner for DRW Financial in Chattanooga, Tennessee.
However, workers don’t get to keep employer contributions until they are vested in the 401(k) plan, which sometimes requires several years on the job.
Traditional Versus Roth 401(k)
Many employers offer traditional and Roth options for their 401(k) plan. Contributions to a traditional 401(k) plan are tax-deferred, so you don’t have to pay income tax on your contributions until you withdraw the money from the account. Roth 401(k)s only accept after-tax contributions, so you don’t get an immediate tax deduction, but withdrawals in retirement from accounts at least five years old are often tax-free. You can save in traditional and Roth 401(k) accounts in the same year as long as your total contributions to both accounts don’t exceed the 401(k) contribution limit for that year.
Traditional 401(k) withdrawals before age 59 1/2 usually trigger a 10% early withdrawal penalty in addition to the income tax due on the amount withdrawn.
“As long as you are over 59 1/2, you can tap into your retirement account with no penalty other than paying the taxes, but if you are below 59 1/2, you may get hit with an early withdrawal penalty,” says Rianka Dorsainvil, founder and president of Your Greatest Contribution in Lanham, Maryland.
A $1,000 traditional 401(k) withdrawal at age 50 would result in $340 in taxes and penalties for someone in the 24% tax bracket.
However, there are a couple of exceptions to the 10% early withdrawal penalty. Hardship withdrawals of up to $100,000 taken in 2020 to cope with coronavirus costs won’t trigger the penalty. If you leave your job during the year you turn age 55 or later, you can take withdrawals from the 401(k) associated with the job you most recently left without having to pay the early withdrawal penalty. If you tap into a Roth 401(k) before age 59 1/2, you will need to pay a 10% early withdrawal penalty only on the portion of the withdrawal that was generated by investment earnings.
Annual 401(k) withdrawals are required for retirees over age 72, and penalties generally apply if you miss a required minimum distribution. However, retirees with be permitted to skip their 2020 required minimum distribution due to provisions of the CARES Act.
If you need access to your retirement savings but don’t want to pay the early withdrawal penalty, many 401(k) plans allow employees to borrow from a 401(k) account. 401(k) participants are eligible to borrow up to 50% of their vested account balance up to $50,000 if the plan allows loans. Then you gradually pay the money back to your account with interest over as long as five years, and you get a longer repayment period if you use the money for your primary residence.
However, 401(k) loans often charge a variety of fees. And if you leave your job while you still have an outstanding 401(k) loan balance, you will need to repay the loan by the due date of your tax return the following year. If you don’t repay the loan on time, the remaining debt is considered a 401(k) withdrawal and taxes and penalties may be applied.
When you leave a job, you have three options to maintain the tax benefits of your 401(k) plan: You can leave your account balance in the existing 401(k) account, some companies will allow you to transfer your account balance into a new employer’s 401(k) plan, or you can roll your money over into an individual retirement account. Traditional and Roth IRAs offer similar tax benefits to 401(k)s, but they provide more investment options and an opportunity to shop around for accounts and funds with low fees.
“In most cases, you’ll want to roll that over to your IRA account where you have better control and more options to invest,” says Eric Nelson, a chartered financial analyst and managing principal at Servo Wealth Management in Oklahoma City. Some retirement savers transfer their 401(k) balance to an IRA each time they change jobs to consolidate their accounts and make their investments easier to track.
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Update 10/19/20: This story was published at an earlier date and has been updated with new information.