Determining exactly how much you'll need for your post-career days might be challenging, but most employees who enroll in a 401(k) plan can plan for a safe retirement.
A 401(k) is a qualified profit-sharing plan where employees can contribute a portion of their wages to individual accounts. These elective salary deferrals are not taxable income for the employee (except for designated Roth deferrals), while the employers have the option of contributing to their employees’ accounts.
What is a 401(k) plan, and how does it work?
A 401(k) is an employer-sponsored retirement saving and investment plan. Employees who contribute to a 401(k) plan receive a tax credit on their contributions. Employee contributions are deducted automatically from their paychecks and invested in funds selected by the employee (from a list of available offerings). Annual contributions to 401(k)s are limited to $19,500 in 2021 and $20,500 in 2022 ($26,000 in 2021 and $27,000 in 2022 for those 50 and over).
The catchy name derives from the portion of the tax code that introduced this form of plan, especially subsection 401(k). Employees contribute to an individual account by having their paychecks deducted automatically. Depending on your plan, you can get a tax reduction either when you contribute money or when you withdraw cash.
Traditional 401(k) vs. Roth 401(k)
When 401(k) plans first became available in 1978, employers and workers only had one option: the typical 401(k) plan (k). Then, in 2006, Roth 401(k)s were available. Former United States Senator William Roth of Delaware was the primary sponsor of the 1997 legislation establishing the Roth IRA.
While Roth 401(k)s were slow to catch on, they are now widely available. As a result, employees frequently choose between Roth and traditional retirement plans.
Employees who expect to be in a lower marginal tax band after retirement should generally choose a regular 401(k) to take advantage of the immediate tax savings.
Employees who expect to be in a higher tax bracket after retirement, on the other hand, may choose the Roth to avoid paying taxes on their funds later. Also important—especially if the Roth has years to grow—is that there is no tax on withdrawals, which means that all of the money contributed grows tax-free over decades.
In practice, a Roth 401(k) plan lowers your immediate spending power more than a standard 401(k). If you’re on a tight budget, this is important.
Because no one knows what tax rates will be in the future, neither sort of 401(k) is guaranteed. Therefore, many financial gurus advise clients to hedge their bets by investing a portion of their money in each.
When you leave your job
When an employee leaves a company where they have a 401(k) plan, they generally have four options:
1. Withdraw the money
Withdrawing money is rarely a good idea unless the employee has a pressing need for cash. The funds will be subject to taxation in the year they are drawn. Unless the employee is over 5912, permanently incapacitated, or meets other IRS criteria for an exception to the provision, the employee will be subject to an additional 10% early distribution tax.
This rule has been suspended for people afflicted by the COVID-19 economic crisis in 2020.
Employee contributions (but not profits) in Roth IRAs can be withdrawn tax-free and penalty-free at any time as long as the employee has had the account for at least five years. They’re still depleting their retirement funds, something they may come to regret later.
2. Roll your 401(k) into an IRA
The employee can avoid direct taxes and keep the account’s tax-advantaged status by transferring the funds to an IRA at a brokerage firm, mutual fund company, or bank. Furthermore, the employee will have access to a broader selection of investment options than they would with their employer’s plan.
The IRS has quite tight guidelines about rollovers and completing them, and breaking them can be costly. Typically, the financial institution in line to receive the funds will be more than willing to assist with the procedure and make no mistakes.
To avoid taxes and penalties, funds withdrawn from your 401(k) must be rolled over to another retirement plan within 60 days.
3. Leave your 401(k) with the old employer
Employers will often allow a departing employee to keep a 401(k) account in their former plan indefinitely, even though the individual is no longer eligible to contribute to it. This usually applies to accounts with a balance of $5,000 or more. In smaller accounts, the employer may force the employee to transfer the funds to another account.
If the old employer’s 401(k) plan is well-managed and the employee is content with the investment options, leaving the money where it is can make sense. Employees who move jobs throughout their careers run the risk of leaving a trail of old 401(k) plans behind them and forgetting about one or more of them. Their successors may likewise be unaware of the situation.
4. Move your 401(k) to a new employer
Your 401(k) balance can usually be transferred to your new employer’s plan. This, like an IRA rollover, keeps the account tax-deferred and avoids paying taxes right away.
Suppose the employee isn’t comfortable making the financial decisions that come with administering a rollover IRA and would instead delegate part of that work to the new plan’s administrator. In that case, this could be a smart move.
How do you start a 401(k)?
Your company is the simplest place to start a 401(k) plan. Many businesses have 401(k) plans, and some may match a portion of an employee’s contributions. The firm will handle your 401(k) paperwork and payments during onboarding in this situation. You may be qualified for a solo 401(k) plan, also known as an independent 401(k) plan if you are self-employed or manage a small business with your spouse (k). Even though another company does not employ them, these retirement plans allow freelancers and independent contractors to fund their retirement. Most internet brokers can help you set up a solo 401(k).
What is the maximum contribution to a 401(k)?
In 2022, the maximum contribution to a 401(k) plan for most people will be $20,500. If you are over 50, you can contribute a $6,500 catch-up payment, bringing your total to $27,000. The employer’s matching contribution is likewise subject to limits: the total employer-employee contributions cannot exceed $61,000 (or $67,500 for employees over 50 years old).
Is it a good idea to make early withdrawals from your 401(k)?
An early withdrawal from a 401(k) plan has a few benefits. If you take withdrawals before the age of 5912, you will be subject to a 10% penalty on top of any taxes you owe. On the other hand, some employers allow hardship withdrawals for unexpected financial demands such as medical bills, funeral expenditures, or property purchases. Although you will avoid the early withdrawal penalty, you will still be responsible for paying taxes on the withdrawal.
What is the main benefit of a 401(k)?
A 401(k) plan allows you to save for retirement while lowering your tax burden. The gains are not only tax-free, but they’re also hassle-free because contributions are deducted automatically from your paycheck. Furthermore, many firms will match a portion of their employees’ 401(k) contributions, thereby providing a free boost to their retirement savings.
What are my 401(k) plan fees?
The 401(k) plan is a complicated machine with many moving components, and costs might pop up at any time. However, we’ll go over what to look for and where to look for them. You might begin by reviewing your 401(k) plan summary annual report. The overall assets and expenses of the plan are shown in this document. Your fund prospectus is another important document. This one breaks down the costs of managing the mutual fund or funds in which you’ve invested.
These are some fees to look out for when studying these and other documents:
- Administration fees: These are costs related to your company’s 401(k) plan’s overall management. Expenses for record-keeping, legal counsel, and services provided to employees, such as instructional seminars, can all be included.
- Expense Ratios: This is the percentage of a fund’s assets used to pay for the fund’s overall management and operation. Because the cost ratio is deducted from the total assets, you and everyone else who invests in the same fund pay for it indirectly through investment results. The expense ratio should be specified in your fund prospectus.
- 12b-1 fees: These are included in the fund’s expenditure ratio if they are existent. The marketing of the fund is usually covered through 12b-1 fees.
- Sales loads: Also known as transaction fees, are costs incurred by the fund manager when buying or selling shares in your fund.
Loads can be divided into two categories. Front-end loads are fees deducted from your original contribution when you acquire shares in a mutual fund.
You will be charged back-end loading when you sell shares beyond a particular period. Some mutual funds combine the two, while others do not. It’s crucial to check your fund’s prospectus to discover if it has any sales loads. These are also paid indirectly by investors in a particular fund through their assets. The expense ratio of a fund does not include sales loads.
- Investment Advisory Fees: These are continuing plan costs connected with managing investment alternatives, often known as account maintenance fees. So, if the plan administrator invests a lot of time and effort into your plan’s investment menu structure, the costs will be high.
Don’t worry if you’re having trouble understanding all of these 401(k) charge distinctions.
You live in the twenty-first century. There are numerous fee analyzers for 401(k) plans available online. Algorithms crunch the numbers for you with these tools. Some are free, while others demand a fee for some information.
What’s in it for you
Many businesses will match a part of your savings. The employer match is the 401(k) benefit that gets all the attention. Stop reading now and fill out the sign-up papers if you work somewhere that will add more money to your account according to how much you contribute — for example, a dollar-for-dollar or 50-cents-on-the-dollar match up to, say, 6% of your contribution amount. If nothing else, donate enough to your account to qualify for the free money.
Play around with our 401(k) calculator to see how your savings will increase over time with a 401(k) and the impact of incremental changes, including any workplace match.
This is an excellent opportunity to point out that there are numerous different types of 401(k) plans, including the standard 401(k) and the Roth 401(k) (k). The typical (or ordinary) 401(k) provides tax benefits on your savings upfront. Because Roth 401(k) contributions are made after-tax dollars, you won’t be able to deduct them from your taxes for that year. But don’t worry; the Roth will be paid out later.
Contributions made before taxes make saving a little easier. Contributions to a standard 401(k) plan are deducted from your paycheck before the IRS deducts its part, thereby doubling the amount you save. Assume Uncle Sam deducts 20 cents from each dollar you earn to cover taxes. To save $800 per month outside of a 401(k), you’ll need to make $1,000 per month — $800 + $200 for the IRS cut. This is what they’re talking about when they claim you won’t miss the money, whatever “they” is in your life. (Here are this year’s contribution limitations to aim towards.)
Contributions can help you save a lot of money on your taxes. Pretax contributions to a typical 401(k) have another advantage besides increasing your savings potential.
Your total taxable income for the year is reduced due to them. Let’s imagine you earn $65,000 per year and contribute $19,500 to your 401(k) (k). You’ll only have to pay income taxes on $45,500 of your paycheck rather than the total $65,000 you earned. Put another way, saving for the future allows you to avoid paying taxes on $19,500.
Uncle Sam does not influence the account’s investments. The force field that protects money in your 401(k) from taxes remains in place until it is deposited. Both standard and Roth 401(k)s fall under this category. Any investment increase is tax-free as long as the money is kept in the account. Not based on interest. On dividends, no. Not on any investment profits, at least for the time being. The traditional 401k(tax-avoidance ) ‘s qualities don’t last indefinitely. Remember when you got a tax break for the money you put into the retirement plan? On the other hand, the IRS ultimately gets around to taking a cut. In technical words, your contributions and investment growth are tax-deferred, meaning they won’t be taxed until you take money out of the account.
Here’s where the Roth 401(k) ‘s superpower is revealed.
A Roth 401(k) allows you to avoid paying taxes straight away. The Roth 401(k) provides a similar tax shelter for your assets while in the account; you owe no taxes on the money as it grows. However, unlike eligible withdrawals from a regular 401(k), you owe the IRS nothing when you start receiving distributions from a Roth.
So, how’s that going? Remember how, depending on the sort of 401(k) plan you have, you can get a tax reduction when you contribute or when you withdraw money in retirement? On the other hand, the IRS can only charge you income taxes once. Because your contributions were made with after-tax cash, you’ve already paid your dues with a Roth 401(k). As a result, when you withdraw money in retirement, you and Uncle Sam are already settled up.
You can take it with you
You can (and should) take your 401(k) with you if you change jobs in the future. You won’t be able to put this in a box with your other stuff; instead, you’ll need to roll it over into a new account — and for many people, converting their 401(k) to an IRA is a terrific option. You’ll want to refer to our 401(k) rollover guidance when the time comes.
Properly planning for retirement
As any mental health practitioner will tell you, comparing yourself to others is unhealthy for your mental health. When it comes to retirement savings, though, knowing what others are doing can be helpful information.
Determining exactly how much money you’ll need for your post-career days might be tricky, but seeing how others are planning—or not planning—can help you set objectives and milestones.
401(k) plan balances by generation
The good news is that Americans are attempting to save more money. According to Fidelity Investments, the average 401(k) plan balance in the fourth quarter of 2019 was $112,300, a financial services corporation with more than $9.8 trillion in assets under management. That’s up from $95,600 in the fourth quarter of 2018.
What does that mean in terms of age? This is how Fidelity calculates the figures.
Twentysomethings (Ages 20 to 29)
- Average 401(k) balance: $10,500
- Contribution rate (% of income): 7%
Thirtysomethings (Ages 30 to 39)
- Average 401(k) balance: $38,400
- Contribution rate (% of income): 8%
IRA contributions climbed by 21% among millennials (defined by Fidelity as those born between 1981 and 1996) in Q4 2018, compared to Q4 2018. This generation contributed $373 million to IRAs in the fourth quarter, up 46% from the previous quarter. Millennials contributed 73 percent of their money to Roth IRAs.
Forty somethings (Ages 40 to 49)
- Average 401(k) balance: $93,400
- Contribution rate (% of income): 8%
Gen Xers’ increase in account balance size could be because they have been in employment for a couple of decades and have been contributing to plans for that long. It’s possible that the slightly higher contribution rate reflects the fact that many people are in their prime earning years.
Fifty Somethings (Ages 50 to 59)
- Average 401(k) balance: $160,000
- Contribution rate (% of income): 10%
The increase in this group’s contribution rate implies that many are taking advantage of the 401(k) catch-up provision, which permits those over 50 to contribute more (an extra $6,500 in 2022) than the usual amount.
Sixty Somethings (Ages 60 to 69)
- Average 401(k) balance: $182,100
- Contribution rate (% of income): 11%
For this bunch, it’s now or never in terms of saving. The high contribution rate indicates that many baby boomers are working during this decade of their life.
Seventy somethings (ages 70 to 79)
- Average 401(k) balance: $171,400
- Contribution rate (% of income): 12%
The Further Consolidated Appropriations Act, which took effect in January 2020, lifted the age restriction that prevented those over 7012 from contributing to traditional IRAs. This provided an extra retirement savings option for persons who are actively employed or own a business.
Of course, we live in a very different world today than we did a few years ago. It’s unclear how the economic effects of the COVID-19 epidemic will affect each generation’s ability to save for retirement.
Retirement savings goals
What should your savings goals be? Fidelity has a lot of specific ideas. The corporation estimates that by the time you’re 30, you should have saved an amount equal to your annual wage.
If you make $50,000 at 30 years old, you should have $50,000 set aside for retirement. You should have three times your annual pay by the age of 40. By the age of 50, you’ll have earned six times your income; by the age of 60, you’ll have earned eight times your salary; and by the age of 67, you’ll have made ten times your salary.
If you retire at the age of 67 and make $75,000 each year, you should have $750,000 in the bank; The average 401(k) contribution rate (as a percentage of pay) for employees in 2019.
There’s also the tried-and-true — and perhaps outdated — 80 percent rule: Save as much as you’ll need to get the job done.
The bottom line
It’s critical to your overall retirement planning goals to have a firm grasp of where you’re spending and saving, as well as a holistic idea of what your lifestyle costs. It is the first step in getting a handle on your retirement planning if you’re feeling overwhelmed by the notion of saving for retirement. You can do it right now.