The 401(k) is one of the best retirement savings tools available to workers today. And with 79% of U.S. employees having access to a 401(k), participating is a great way for most adults to grow their nest eggs. Here are a few basic things you should know.
1. How much am I allowed to contribute?
Continue Reading Below
One great thing about 401(k)s is their generous annual contribution limit. Currently, workers under 50 can put up to $18,000 a year into a 401(k), while those 50 and older can contribute up to $24,000. Better yet, come 2018, these limits will increase by $500, so next year's thresholds are $18,500 for younger workers and $24,500 for the 50 and over set.
Of course, not everyone can manage to contribute the maximum amount each year. But if you can't max out, at least be sure to put in enough of your own money to snag whatever matching dollars your employer offers. The majority of companies that sponsor 401(k)s match employee contributions to some degree, and that's really just free money waiting to be snapped up.
2. How much money will I save on taxes by contributing?
Not only can a 401(k) be instrumental in helping you save for retirement, but it can also serve as a tax break at present. That's because 401(k) plans are funded with pre-tax dollars, and your savings will depend on the amount you contribute coupled with your effective tax rate.
If you typically lose 25% of your income to taxes, and you opt to contribute $10,000 in a given year, you'll shave $2,500 off your IRS bill. Put in $15,000, and you'll lower your taxes by $3,750. Basically, the more you contribute, the more you stand to save, which is why it pays to get as close to maxing out as you can.
3. When can I access the money in my account?
In exchange for the aforementioned tax break, the IRS has one key requirement: You're not allowed to touch the money in your 401(k) until you reach age 59-1/2. Access that money sooner, and you'll face a 10% early withdrawal penalty on whatever funds you remove.
But penalties aside, the biggest reason you shouldn't tap your 401(k) early is that if you do, you'll have less money available in retirement. Not only that, but since the money in your 401(k) gets invested, if you take an early withdrawal, you'll lose out on whatever growth that sum could've achieved. There are plenty of reasons why taking early 401(k) distributions is a bad idea, so once you fund that account, pledge to keep your money locked away until you're older and ready to retire.
4. Will I pay taxes when I withdraw from my 401(k)?
Unless you have a Roth-style 401(k), your withdrawals, whether you take them early or in retirement, will be taxed as ordinary income. This means that the total amount you accumulate won't be yours to enjoy in full; rather, you'll need to plan on paying a portion of your total to the IRS. The good news, however, is that any growth your investments achieve over the years is tax-deferred, meaning you won't owe the IRS any money on your investment gains until the time comes to take withdrawals.
5. What happens if I leave or lose my job?
You have several options for your 401(k) once you're no longer employed by the company sponsoring that plan. For one thing, you can typically leave your money where it is, though that's generally not the best idea. Another option is to either roll your 401(k) into your new employer's plan, or roll it into an IRA that you open separately. Either way, rest assured that you won't forfeit that cash should your employment arrangement come to an end.
6. Are 401(k)s different from IRAs?
IRAs and 401(k)s have similar features. Both offer tax-free contributions and tax-deferred growth on investments, but whereas you can put up to $18,000 or $24,000 into a 401(k) at present, IRAs max out at $5,500 for younger workers and $6,500 for those 50 and over. Furthermore, the annual contribution limit for IRAs won't be increasing in 2018, thus widening the gap between IRA and 401(k) maximums.
On the other hand, IRAs tend to offer more investment choices than 401(k)s. This can be advantageous for two reasons. First, the more options you have, the greater your chances of finding investments that align with your personal strategy. Furthermore, the more low-cost investments you have access to, the less you'll lose in fees. If you don't have access to a 401(k), then it definitely pays to save for retirement in an IRA. Furthermore, you can fund a 401(k) and IRA simultaneously, though if you do, depending on your financial circumstances, you may not end up getting a tax break out of the latter.
Now that you're clear on how 401(k)s work, it's time to think about funding your account. The sooner you do, the more you stand to gain in the long run.
The $16,122 Social Security bonus most retirees completely overlook If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.