How Do 401(k)s Work?
401(k)s are the most popular retirement vehicles. Knowing how 401(k)s work can help decide if saving for retirement in one is your best option.
When it comes to saving for retirement, the most common option is the 401(k). About 59% of working Americans have access to a 401(k). Despite the majority of workers having access to 401(k)s, only 32% actually save for retirement in one. To understand if you should join a 401(k), let’s take a look at exactly how 401(k)s work.
The 401(k) is a type of retirement account that is provided by an employer through their benefits package. Contribution and growth are tax-deferred until retirement, meaning you don’t pay taxes until you withdraw funds. Your employer can also contribute to your 401(k) through matching contributions. However, because a 401(k) is a designated retirement account, the IRS imposes strict rules regarding them. Withdrawing funds before retirement could leave you facing penalty taxes on the amount you took out.
By diving into each characteristic of 401(k) accounts, you can better decide if joining your employer’s 401(k) is the best retirement option for you.
Who is eligible to join a 401(k)?
Once you’ve been working for a company for a year, an employer must allow you to join their 401(k) plan without any restrictions.
If you change jobs later on in your career, you won’t have to wait a year to join a new employer’s plan. You’ll have already met the one year of service requirement. However, if your new employer implements a service period to join their 401(k), you’ll have to wait.
Some companies require their new hires to wait a period of time—usually 90 days—in order to participate in their benefits package such as health insurance, life insurance, and yes, their 401(k) plan. If the employer has this policy, there isn’t anything you can do; you’ll have to wait to join their 401(k).
How do 401(k) contributions work?
Once you’ve joined your employer’s 401(k), you’ll need to elect how much you want to contribute to your 401(k) account. The IRS sets a limit on how much you can contribute to your 401(k) to $19,500 annually in 2021. An additional catch-up amount of $6,500 is allowed for individuals over 50.
The key feature of 401(k) contributions is that they are made using pre-tax dollars. When you set up your contributions with your 401(k) plan’s administrator, they will take the percentage of your wages out of your paycheck before taxes are calculated. This reduces your tax obligation throughout your working years.
Additionally, because you’re paying taxes upfront, you’re able to contribute a higher dollar amount to your 401(k). For example, if you make $90,000 annually and contribute 10% towards your 401(k), you’ll be saving $9,000 a year for retirement. However, if you deduct taxes first, it’ll be much less. At a 25% tax bracket, you’ll only be saving $6,750 roughly. This difference adds up over time when considering the compounding growth your 401(k) will receive.
What are employer matching contributions?
Employers can offer to match a certain percentage of their employees’ contribution. According to the National Compensation Survey, the average employer match is 3.5%.
In the previous example of a $90,000 annual salary and your employer matched 5%, they would be adding $4,500 to your 401(k). In addition to the $9,000 you saved, your total contributions for the year would be $13,500.
You can see why maximizing your employer’s match is vital in maximizing your retirement savings potential.
Lastly, the IRS limits the total contribution amount—the amount both you and your employer can contribute—to $58,000 annually and $64,500 for those over 50.
How do taxes work on 401(k)s?
Although 401(k) plans are tax-deferred, they are not tax-exempt. The contributions both you and your employer made, along with their growth, are not taxed until the funds are withdrawn.
There is no specific 401(k) tax; instead, 401(k)s are taxed as regular income. When withdrawals are made from a 401(k), that amount is added to any other adjusted gross income you made during that same year. Then taxes are calculated based on the individual tax rate into which you fall.
It’s essential to discuss the tax implications of any 401(k) withdrawal with a tax professional. If taking withdrawals bumps you into a higher tax bracket, you may want to consider waiting in order to reduce your tax burden.
Are there penalties for 401(k)s?
Yes, the IRS imposes a 10% penalty tax for any withdrawal that is done before 59½. This penalty is in addition to any income tax that is due.
However, there are ways to avoid paying the 10% penalty on withdrawals made before 59½. If you leave your job after 55, you can begin withdrawing funds from the 401(k) you had with that company. Additionally, if you meet the requirements for a hardship withdrawal, the IRS waives the 10% penalty. Hardship withdrawals are classified as:
- Certain medical expenses
- Home-buying expenses for a principal residence
- Up to 12 months’ worth of tuition and fees
- Expenses to prevent being foreclosed on or evicted
- Burial or funeral expenses
- Certain expenses to repair casualty losses to a principal residence (such as losses from fires, earthquakes, or floods)
It’s important to note that even if the penalty tax is waived, income taxes are still due for any withdrawal from a 401(k) account.
How do 401(k) loans work?
Another way to withdraw funds from a 401(k) is through a 401(k) loan. Most 401(k) plans allow 401(k) loans; however, employers aren’t required to allow 401(k) loans.
To take out a 401(k) loan, you’ll need to go through your plan’s administrator. The process takes about one to two weeks, and you can receive your funds either by check or direct deposit. The loan amount is limited to $50,000 or 50% of the 401(k) balance, whichever is less, and the loan must be repaid within five years. If the loan is defaulted upon, the IRS will tax the loan amount as an ordinary withdrawal and charge the 10% penalty tax. If you leave your job with an outstanding 401(k), they may require you to repay the remaining balance within 60 days.
What investment options do 401(k)s have?
The investment options provided to 401(k) accounts are decided by the plan’s administrator. The typical amount of investment options is about 19 different funds, including target-date funds, mutual funds, index funds, bonds, and even stock in the company itself.
Many 401(k) plans default to investing into a target-date fund that coincides with your estimated retirement date. Target-date funds reallocate the asset holdings to match the account holder’s risk tolerance as they near retirement—shifting more towards less risky investments like bonds than riskier options like stocks.
You can change the funds your 401(k) is invested in at any time. If your plan has an online portal, you can move your investments around to different funds. If not, your plan’s administrator or human resource department can facilitate any changes to your 401(k).
How do withdrawals from a 401(k) work?
Withdrawals from a 401(k) can be made at any time. However, withdrawals that don’t meet the IRS’s guidelines will be subject to a 10% penalty tax. Also, any withdrawal from a 401(k) will be assessed income tax as the contributions made to the account were not taxed.
Additionally, the IRS requires 401(k) account holders to take mandatory distributions at 72—70 ½ if you reach 70 ½ by January 1, 2020. Fail to withdraw the required amount, the amount that wasn’t removed will be subject to a 50% tax until the amount is withdrawn.
What are early retirement withdrawals?
Early retirement withdrawals are distributions made before the account holder reaches 59½. The options to take early retirement distributions are Substantially Equal Periodic Payments (SEPPs), withdrawals after 55 if you leave your job, hardship withdrawals, and withdrawals that meet specific criteria.
Substantial equal periodic payments can be taken out at any time. However, once an account begins to receive SEPPS, the account must continue to receive distributions for at least five years or until they reach 59½. If SEPPs are taken out too early, this could drain a 401(k) account by the time the person retires.
Distributions can be made after 55 if the account holder leaves their job. This only applies to the 401(k) held at the company you leave. You will need to wait until 59½ to withdraw from any other old 401(k)s. It’s a good idea to rollover your old 401(k)s into your current 401(k) to avoid this.
How do I withdraw my 401(k) during retirement?
You have a couple of options to take distributions from your 401(k) during retirement, a lump-sum distribution, or period payments.
A lump-sum distribution is just that. You can withdraw the entire amount in your 401(k) and deposit it into a liquid account for you to use. However, you’ll want to budget this money if you plan on living off of it throughout your retirement. The last thing you want to happen is running out of money before you die.
Period payments are perhaps the most sensible option to receive 401(k) distributions during retirement. You can elect to receive monthly or quarterly distributions and choose how much you want to receive each time. However, once you turn 72, you’ll need to make sure you’re withdrawing the required minimum amount as set by the IRS.