As a component of benefits offered to employees, 401(k) plans are a very popular way to accumulate tax-deferred income and earnings for retirement.
Employers offer 401(k) plans as a way to help their employees save for retirement. You choose how much pre-tax income you wish to contribute and that amount is automatically deducted from your paycheck and placed into your account within the 401(k) plan. Your retirement savings can continue to grow tax-deferred until you make a withdrawal. You do not pay taxes on your salary deferrals or earnings until you take a withdrawal from the plan.
Generally, if you take the distribution after age 59½ there is no tax penalty. Distributions made after you've separated from service from that employer, if the separation occurred in or after the year you reached age 55, may also be made without an early withdrawal penalty.
Key Features
Because your employer sponsors the 401(k) plan, there may be other valuable benefits offered in addition to salary deferrals. Check your plan carefully. The following are key features provide a brief overview to assist you:
- Optional participation: Although some plan sponsors automatically enroll employees to promote plan participations, 401(k) plan participation is still optional. Check with your employer to determine how you can enroll.
- Contribution rate: You can choose the amount you want to contribute each payroll up to established IRS limits. You will also be permitted to change your contribution rate once you are in the plan.
- Available investments: You can choose from a variety of investment choices selected by your employer.
- Deferred taxes: Not only do your pre-tax contributions help lower your taxable income each pay period, but all earnings on your contributions grow tax deferred. Note: Some plans offer a Roth 401(k), which permit savings on an after tax basis. You will not be taxed on either the contributions or earnings until you make a withdrawal. Withdrawal are taxed as ordinary income in the year the money is distributed.
- Optional employer match: To provide an extra boost to retirement savings, many employers match a percentage of an employee’s contribution which will be given to the employee once she is vested.
- Accessing funds during employment:
- Loans — as an optional feature your employer may permit you to borrow against your plan account up to specified IRS limits.
- Hardship Withdrawals — Understanding that certain hardships arise, the IRS permits plans to allow distributions for certain hardship reasons.
- Portability: If you leave your job, you may be able to remain in the plan, or rollover your 401(k) funds into an IRA or another 401(k).
- Support: Your 401(k) plan provider typically offers many free tools and resources to help you establish savings goals, measure your progress, and to see how financially close you are to meeting your retirement goals.
- Higher contribution limits: The contribution limit in 2021 is $19,500 with an additional $6,500 catch-up contribution allowed for those age 50 or older.
- Roth account option: May also be offered by a plan sponsor under 401(k), 403(b), or governmental 457(b) plans. Roth contributions are made after you’ve paid taxes on the income, but qualified distributions may be taken tax-free in retirement.
Additional considerations
- You must be employed by a plan sponsor offering a 401(k) plan to participate. Check with your employer for their specific requirements.
- If you leave employment, you will no longer be able to contribute to the plan.
- Some employers will let you keep your savings in their plan after you leave.
- You can always combine all of your old plans into one rollover IRA or in most cases, into the 401(k) plan offered by your new employer.
FAQs
Stowing savings in a 401(k) plan is a great way to prepare for your golden years. For one thing, because taxes are deferred until you retire, your earnings will compound – and grow faster than if you had to deduct taxes from the earnings. For another, companies often offer matches, which grow your nest egg even more.
Is a 401k the best way to save for retirement? ›
A 401(k) plan is one of the best ways to save for retirement, and if you can get bonus “match” money from your employer, you can save even more quickly. A 401(k) plan is one of the best ways to save for retirement, and if you can get bonus “match” money from your employer, you can save even more quickly.
Why is 401k the best retirement plan? ›
One of the most powerful advantages of participating in a 401(k) is the money you save in taxes. Your 401(k) contributions are taken out of your paycheck before taxes are deducted from your paycheck. That means your gross income is reduced, so you pay less in income taxes.
What is the big benefit of a 401 K that helps you save more? ›
The earlier you start investing, the more time your money has to grow. One of the biggest advantages of investing in a 401(k) early is compound interest. Compound interest is when you earn interest on the principal amount of an investment plus any accumulated interest, i.e. it's when you earn interest on interest.
What are the best ways to save for retirement? ›
Saving Matters!
- Start saving, keep saving, and stick to.
- Know your retirement needs. ...
- Contribute to your employer's retirement.
- Learn about your employer's pension plan. ...
- Consider basic investment principles. ...
- Don't touch your retirement savings. ...
- Ask your employer to start a plan. ...
- Put money into an Individual Retirement.
The value of 401(k) plans is based on the concept of dollar-cost averaging, but that's not always a reliable theory. Many 401(k) plans are expensive because of high administrative and record-keeping costs. Nonetheless, 401(k) plans are ultimately worth it for most people, depending on your retirement goals.
What is a disadvantage of using a 401 K for retirement savings? ›
Most plans have limited flexibility as it relates to quality and quantity of investment options. There can be early withdrawal penalties equal to 10% of the amount withdrawn before age 59 1/2.
What are five benefits of a 401k? ›
Reasons employers should offer 401(k) plans
- Attract and retain employees. ...
- Assist employees in saving for retirement. ...
- Potential tax saving advantages of a 401(k) plan. ...
- 401(k) plans are easy to set up and maintain. ...
- A financial wellness program can help increase employee productivity. ...
- Contributions are made pre-tax.
The 401(k) is one of the most popular retirement plans for good reason. It offers a way to save for the future and receive tax benefits — both lowering current taxable income and deferring taxes on investment gains — for doing so.
Which 401k plan is best? ›
Our picks at glance
| Provider | Payroll integration | Recordkeeping support |
|---|
| ShareBuilder 401k | Yes | Yes |
| Fidelity Investments | Yes | Yes |
| T. Rowe Price | Yes (depending on tier) | Yes |
| Merrill Edge | N/A | Yes |
5 more rowsApr 11, 2024
Good alternatives include traditional and Roth IRAs and health savings accounts (HSAs). A non-retirement investment account can offer higher earnings but your risk may be higher. Investment accounts don't typically come with the same tax advantages as retirement accounts.
Why is a 401 K better than a savings account? ›
With a traditional 401(k), you make contributions with pre-tax dollars, so you get a tax break up front, helping lower your current income tax bill. Your money—both contributions and potential earnings—grows tax-deferred until you withdraw it. At that time, withdrawals are taxed at your current tax rate.
Can you save too much in 401k? ›
People who overcontribute to a 401(k) can be subject to consequences such as being taxed twice on the amount above the contribution limit of $23,000 in 2024 ($30,500 for those age 50 or older) and a 10% early distribution tax if you're under 59.5 years old.
What is the $1000 a month rule for retirement? ›
The $1,000-a-month retirement rule says that you should save $240,000 for every $1,000 of monthly income you'll need in retirement. So, if you anticipate a $4,000 monthly budget when you retire, you should save $960,000 ($240,000 * 4).
Is saving $100 a month for retirement good? ›
Your Retirement Savings If You Save $100 a Month in a 401(k)
If you're age 25 and have 40 years to save until retirement, depositing $100 a month into a savings account earning the current average U.S. interest rate of 0.42% APY would get you to just $52,367 in retirement savings — not great.
Can I retire without a 401k? ›
Bottom line. Just because your company doesn't offer a 401(k) doesn't mean you can't save for retirement. Take advantage of other workplace programs, pay off any high-interest debt and invest in an IRA or brokerage account.
Is it better to invest in a 401k or savings account? ›
Saving is generally seen as preferable for investors with short-term financial goals, a low risk tolerance, or those in need of an emergency fund. Investing may be the best option for people who already have a rainy-day fund and are focused on longer-term financial goals or those who have a higher risk tolerance.
Is maxing a 401k enough for retirement? ›
“Unless you started with a lot of money, or you save a tremendous amount of money each year, just maxing out your 401(k), even with an employer match, isn't going to get you there,” said Quintin Hardtner in an interview, a financial professional with Hardtner Wealth Strategies in Shreveport, Louisiana.
Can you retire comfortably with a 401k? ›
Now, most financial advisors recommend that you have between five and six times your annual income in a 401(k) account or other retirement savings account by age 50. With continued growth over the rest of your working career, this amount should generally let you have enough in savings to retire comfortably by age 65.
