What is a 401(k) Plan?

When planning for your future, it’s important to determine when you think you’ll retire. More importantly, how will you be able to afford retirement?

In order to retire, you need to save enough money to fund your lifestyle without needing to work. Experts say your retirement income should be 80% of your pre-retirement income. This means that if you’re earning $50,000 per year, you’ll likely need to live on around $40,000 per year during your retirement.

One of the best ways to save for retirement and build wealth over time is with a 401(k) plan. Read on to learn more about this type of retirement account.

What is a 401(k) Plan?

You might have heard the term 401(k) before, especially if you landed a job and your new employer offers this as part of the benefits package.

Backing up a bit, a 401(k) is basically a retirement savings plan sponsored by an employer. It allows you to save and invest a portion of your income before taxes are deducted from your paycheck.

This option can only be offered by your employer and it’s not a savings account. The money you put into your 401(k) is not easily accessible as it’s set up to grow over time.

Since 401(k) contributions are tax-deferred, you can deduct the amount you contribute from your income each year, thus lowering your taxable income. However, you will have to pay taxes on the money once you retire and start withdrawing it.

How Does a 401(k) Plan Work?

Contributing to a 401(k) plan is easy. You simply opt-in if your employer offers a 401(k) option. This may involve filling out some initial paperwork.

From there, you can choose how much of your paycheck you want to contribute. Some employers even offer to match your contributions and this is great because it’s just like getting free money.

For example, your employer may offer to match every dollar you contribute to your 401(k) up to five percent of your gross pay for the year. If your salary is $60,000, this means your employer can contribute up to $3,000 to your 401(k).

How Much Can You Contribute To a 401(k)?

This year, the maximum 401(k) contribution limit for anyone under 50 is $19,000. This is subject to change in any given year.

Be sure to research each year’s contribution limits at the beginning of the calendar year to see if there are any changes. This will help you plan your contributions.

What Are Roth 401(k)s and IRAs?

A 401(k) plan isn’t the only type of retirement plan available to you. A Roth 401(k) is similar to a 401(k) – except that your account is funded with after-tax dollars.

This means that you pay taxes on your income before you contribute to your retirement plan, yet you make tax-free withdrawals during your retirement years.

An IRA, on the other hand, is an individual retirement account. There are two main types: traditional IRA and Roth IRA. A traditional IRA is funded with pre-tax dollars while a Roth IRA is funded with taxed dollars. The main difference is whether you’ll pay taxes when you contribute (Roth IRA) or when you retire (traditional IRA).

Regardless of which option you choose, an IRA can be used as a separate, alternative retirement savings tool or it can be used in addition to your 401(k) plan.

The annual contribution limit for an IRA is $6,000 if you’re under 50 and $7,000 if you’re over 50. There are also income limits to be eligible to contribute to an IRA.

How Much Should You Contribute To Your 401(k)?

After recognizing the importance of 401(k) plan, your next question may be: How much should I contribute year after year.

The amount you put into your account depends on your retirement goals. So, think about when you want to retire and how much you’ll need to live on each year.

Fidelity recommends saving ten times your income by the time you hit 67. To do this, you’ll need to save around 25% of your income each year starting in your mid-20s. This 25% savings rate may sound high, but it includes 401(k) contributions, an employer match, cash savings, and debt repayment. Remember: You can always adjust your 401(k) contributions depending on your age and current situation.

If you can’t afford to max out your retirement account each year, you can still aim to contribute enough to get your employer match if it’s offered. This is (practically) free money that you don’t want to leave on the table. So, assess your situation every six to 12 months to see if you can increase your contributions over time.

The great thing about a 401(k) plan is that you don’t see the money you contribute so you won’t miss it much.

What Does It Mean to Be Vested in Your 401(k) Retirement Plan?

The term ‘vesting’ means ownership.

Being 100% vested means that you own your entire 401(k) balance and it can’t be forfeited or taken back by your employer for any reason.

Some employers, however, don’t give you full ownership of your 401(k) match dollars right away. For example, your employer may require you to be on the job for at least three years before you can be 100% vested in your 401(k) balance.

This means that if you leave your employer before that three year mark, you could lose some of the match contributions.

When Can You Get Your Retirement Money?

Generally, you’ll want to wait until you’re 59 ½ to start withdrawing money from your 401(k). Why? Because if you withdraw money before that age, you may face a 10% early withdrawal penalty from the IRS. This means you may have to pay taxes on any amounts you cash out (since you contributed pre-tax dollars).

However, there are some cases where you can avoid the penalty fee. Here are some of these situations:

  • Withdrawing funds as a down payment on your first home purchase
  • Unreimbursed medical expenses that exceed 7.5% of your adjusted gross income
  • Education expenses that fall under a ‘hardship withdrawal

If possible, it’s best to avoid early withdrawals to avoid any chance of receiving a penalty.

The Wrap-Up

A 401(k) plan is a great retirement tool that can help you save money to retire comfortably.

When it comes to deciding how much to contribute, look at your budget and determine how much money you can save. If you can get an employer match, try to contribute enough to get the full match and be mindful of vesting rules.

And remember: It’s important to start somewhere and set goals to contribute more over time.

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