Beginner’s Guide to 401(k)s: Everything You Need to Know
In the United States, there are plenty of options to secure your future financially. Among the multitude of retirement savings plans, 401(k) is especially notable for its rapidly rising popularity . However, if you are one of those who are thinking about investing your money in this plan, it's important to understand what you will get in return.
In this guide, you will learn the 401(k) definition, its advantages, main types, steps to enroll, and best practices for successful account management.
What Does a 401(k) Mean: Definition And Its Benefits
How does a 401(k) work? To put it simply, it is a type of retirement and investing plan offered by employers. It is named after a subsection of the tax code for ease of reference.
The way it works is that a certain portion of an employee’s salary goes into their retirement plan. The benefits associated with 401(k) investing include the following:
Possible contribution match
One of the significant advantages of 401(k) is that your employer may also help you save for future retirement. This is referred to as a 401(k) match, but the actual percentage of the match can differ. For example, one company may offer a 50% match on your investment, while another employer may offer a full one.
Contributed money is yours
While this retirement investment plan is associated with a workplace, you can still keep your plan even if you quit a particular job. Then, you can either roll it in your IRA or a new 401(k) plan offered by another employer. Depending on a vesting schedule, you may have a chance to take a contributed match from a previous employer.
Another advantage associated with 401(k) is that contributions are made automatically from your paycheck. This way, there is no temptation to skip a month, and it is important for those who struggle to put money aside.
When you choose this type of plan, particularly at an earlier age, you will benefit from compounding, meaning you get returns on the previous investment gains. This is a passive way to increase your retirement savings, so it can be a huge benefit for some people.
Roth 401(k) or Traditional 401(k): What’s the Difference
Now that you have an answer to ‘What is a 401(k)?’, it is worth discussing its two types — traditional and Roth, that mainly differ in how they are taxed.
With the traditional option, which has been around the longest, contributions are tax-deferred. This means that you don’t pay the tax when you make contributions, but they are applied when you withdraw money. If you choose a Roth option, you will have to pay taxes on your 401(k) investments upfront, but when you retire, you will be able to withdraw money without any additional fees.
As for the contribution limits and withdrawal rules, they are the same for Roth and traditional plans. In 2024, the contribution limit is $23,000. As for withdrawing your savings, this is possible penalty-free only from the age of 59.5 and up.
To decide between Roth and traditional, you should consider your present tax situation and the one expected at the time of retirement. If you think that your tax rate will increase over time, it is better to go with a Roth 401(k). If you expect the opposite, then it is reasonable to choose a traditional variant.
Steps You Need to Take to Enroll in a 401(k) Plan
Enrollment in a 401(k) plan differs from one workplace to another. Sometimes, employees are enrolled automatically when they are hired. If that's the case, you can always opt out. In other companies, an employee can enroll on their own, or they may be allowed to enroll only after working for some time.
The basic steps to enter the program include the following:
- Decide on the investment percentage.
- Choose your investment option and its type.
- Pick a beneficiary.
- Contact your human resources representative to discuss your options and how you should fill out an enrollment form.
You are not required to select a beneficiary who will inherit your 401(k) in case of death, but it is advisable. A beneficiary can be almost anyone, including charity organizations.
As for the investment options, they can vary greatly. Those who are at the beginning of their careers can go for more aggressive stock funds to ensure significant long-term growth. Individuals who are about to retire can go for more conservative variants, such as bond funds and dividend stock funds, with a higher level of stability.
Best Practices for Effective 401(k) Plan Management
A retirement strategy involves not just choosing a plan but also managing it. It is recommended to check your 401(k) performance at least once a year and pay attention to the following:
- Performance. By monitoring your balance, you can see how your investments perform over time. You can see whether there are assets that underperform so you can make changes.
- Fees. The next thing to pay attention to is fees, which may significantly affect your savings. If you notice that fees are unreasonably high, you can explore some other investment options with lower fees.
- Risks. It is also important to keep your risk tolerance in mind. You should make sure your investments align with your long-term goals and that your 401(k) is sufficiently diversified.
What to Know Before Withdrawing Funds from 401(k) Plan
When you contribute to one of the 401(k) retirement plans, you should be aware that there are penalties for early withdrawal. To avoid them, you should wait until the age of at least 59.5 to withdraw your money. Otherwise, you will have to pay a 10% penalty in addition to income tax.
Some situations when you don’t need to pay a penalty include but are not limited to becoming disabled and leaving your job after turning 55. Once you turn 59.5, you can begin withdrawing money from your retirement savings without penalties. After the age of 72, withdrawals are required.
If you are interested in rolling over your 401(k) plan to another account or plan, there are a few options available:
- Direct rollover. There are no tax penalties for rolling over your 401(k) plan into another one if you take money from an old account to a new one without any changes. If your new plan allows this transfer, this is the easiest option, and all you have to do is inform your plan administrator.
- Rollover to an IRA. Another alternative is rolling over your 401(k) to an IRA. In some cases, you may get lower fees, so it’s an option to keep in mind. It is possible to perform rollovers to a traditional IRA and a Roth IRA. In the case of a Roth IRA, you will owe taxes on the rolled-over sum in the year that this transition is performed.
Now that you understand the meaning of a 401(k) plan and its benefits, you can make a more informed decision about enrolling. Whether you choose Roth 401(k) or traditional 401(k), it is important to manage your account to evaluate risks and view fees so you can make changes if necessary. Overall, a 401(k) is a great option for many people with its automatic payments and employers’ match on investments.