Confused about how 401(k)s work? Laura explains the rules for using these tax-advantaged retirement accounts, including employer matching, contribution limits, rollovers, withdrawals, loans, and more.
Most people know, they should say for retirement, however, using a 401k may seem too overwhelming or complicated, and that may prevent many people from getting started. When I was in my twenties, I did not invest in my company’s 4 0 1 KK because I wasn’t sure what would happen if I left my job, not understanding the retirement account rules held me back when I first started out. And I don’t want that to happen to you. If you wanna learn more about 401ks for workers and the self-employed stay with me, and I’ll also cover some listener questions and at the end of the show related to investing for retirement, hi friends, and thanks for joining me this week. I’m Laura Adams, a personal finance and small business expert and author. Who’s been hosting the money girl podcast since 2008. The mission here is simple. It’s to help you get the knowledge and motivation to prioritize your finance, build wealth and have more security and less stress.
Every show is designed to help you come away with practical advice and tips to make better money decisions and take your financial life to the next level. So I would love for you to subscribe to the show so you can make sure that you’ll get every weekly episode also about participating. You can send me your money, questions, or comments. One way to do that is by leaving a voicemail message. 24 7. All you have to do is call 3 0 2 3 6 4 0 3 0 8. And you can also email me using my contact page. Laura D adams.com or connect with me on Instagram at Laura D. Adams. And don’t forget that every week we publish a companion blog post for every podcast episode they’re published over in the money girl [email protected] today’s episode is number 709 called your complete to 401k retirement accounts. While 401ks do come with a number of critical IRS regulations, you have to know they’re not as tricky to master as you might think.
So if you’re lucky enough to work for an employer that offers a 401k, participating can be a powerful way to build well for retirement. And also you can have a solo 401k if you’ve got self-employment income. So in this podcast, I’m gonna cover everything you need to know about 401ks. So you can use them to accumulate a healthy nest egg and have a lot more security in your financial future. So we’ll start with some just basic definition of what is a 401k and in its simplest terms, it’s an employer sponsored account for workers to save money for retirement. And as I mentioned, if you’re self-employed, you can also have a solo 401k, and there are two main types. You’ve got traditional 401ks and Roth 401ks with a traditional 401k, your employer, or you. If you’re self employed with a solo 401k, you can deduct contributions from your paycheck before taxe get withheld.
So you’re contributing on a pre-tax basis and putting that money straight into your 401k account. And the big benefit you get is that you defer paying tax on both your deposits, that the money that you’re putting into the account and the investment earnings or gains those deposits that you’re putting in the 401k. Now they will get taxed. Eventually you have to pay tax on your 401k distributions in retirement, but you get to avoid paying tax in the current year. Now with a Roth 401k, the rules are very different. Your employer, or you will make contributions on an after tax basis. So what happens is you’re paying tax upfront on your contributions, but all of the growth in the account. So your investment gains your earnings, all of that gets to grow in the account entirely tax free. So when you take withdrawals of your money from a Roth account in retirement, you don’t pay any tax.
So those investment gains could be massive. And, and that’s a huge potential tax savings. Now, a lot of you may know that to qualify for a Roth IRA, you do have to meet certain annual income requirements. If you come is too high, you won’t qualify to make Roth IRA contributions, but that’s not the case for a Roth 401k or a Roth solo 401k. They’re great options because they have no income limits. You can make very high levels of income and still qualify for a Roth 401k at work, or a solo Roth, 401k that you have on your own as a self-employed person. Now, one of the most valuable benefits that you, you hear a lot about a 401k is the matching. If you participate in a 401k that your employer incentivizes you by paying a match, that’s getting free additional money in the account. So let me give you an example.
Let’s say your company matches a hundred percent of your contributions up to a certain percentage of your salary, or it could be 50% of your contributions up to a specific limit. So here’s an example. Let’s say you earn $50,000 year and you get a 50% match from your employer for your contributions up to 6% of your salary. So if you were to save $3,000 and your 401k, your employer would deposit $1,500 for you, that’s an instant 50% return on your investment. Not bad right now. Let’s take that example a little further. Let’s say you’re getting this full $1,500 match year after year for the next 30 years, you would have an extra $127,000 in your account to spend in retirement. And that’s a conservative estimate because it doesn’t even account for any potential increases in your wages. So if you are, you know, contributing more on a percentage basis, as your income goes up, you could be getting higher amounts of matching.
So, you know, $127,000 additional again, it’s, that’s a very conservative estimate. So I tell you this because you need to understand that employer matching on a 401k is a very valuable benefit, which is why I always say, be sure that you’re contributing at least enough to max out that match. Now, now there’s only one catch that you should know about 401k matches. Some employers impose a vesting schedule, vesting prevents you from owning those matching funds until you’ve been employed for a set number of years. So that means if you leave your job ahead of that vesting deadline, you could force, but some, or even all of your matching funds, however, there’s never a vesting schedule for the contributions that you make from your paycheck. So the, the money that you put in on your own, you are always 100% vested in the money that you put in a 401k that money can never be lost.
If you change jobs or get, you know, or, or whatever may happen. And you may be thinking, well, Laura, what if I’ve got a 401k? And my employer does not give me any matching funds? Well, you know, there’s no law that says an employer has to match. If they do match, that’s a very generous benefit, but even if they don’t match, I wanna encourage you to fully participate in a 401k at work and max it out every year. The benefits that you’re gonna get just from, you know, the tax savings alone is so, so worth it. So let’s talk about the 401k contribution limits for 2021. You can contribute up to $19,500, but that number is going up. So next year for 2022, you can contribute up to 20,500. So that limit is going up a thousand dollars to a 401k. Now, if you’re over age 50, you can put in an additional amount.
So if you’re over age 50 and 2021, you can contribute up to $20,000. And in 2022, you can contribute up to $27,000 to the 401k. If you’re over age 50, also note that the annual contribution limit does not include any employer matching. So that means E even if you max out a 401k, your employer can put in as much as they want. That’s just icing on the cake. You have to meet those contribution limits from the paycheck, but your employer can put in money that exceeds those contribution limits for the year. A common question I get is, well, are what should I do if I need to take money out of my 401k? Well, I’m gonna say in general, you should not be putting money into a retirement account that you think you might need. You know, this, these accounts are really set up for the future and they’re gonna penalize you if you take money out early.
So, you know, it is just an, not a good idea to put money into an account that you think you’re gonna need to pull out. So here’s what happens. Um, if you go against the rules and you take an early withdrawal before the age of 59 and a half, you’re gonna have to pay income tax, plus a 10% early withdrawal penalty on those amounts. And that applies you the traditional account. But if you’ve got a Roth account in general, you’re only going to pay tax and an early withdrawal penalty on the investment gains in the account. Remember that you pay tax upfront with a Roth. So with the contribution portion, you’ve already been taxed on that. Now there is an exception to this penalty that mentioned, and it’s called the rule of 55. This says that you can take distributions that are penalty free. If you leave your job after age 55.
So if you wanna retire early, that’s giving you a way to do that. So you do still have to pay income tax on withdrawals that we’re not previously taxed. Even if you leave at age 55, but you’re not gonna have to pay that hefty 10% penalty. Additionally, you can skip the early withdrawal penalty for qualified hardships. So these include becoming disabled paying for a certain amount of education expenses, either for yourself or your family, or avoiding foreclosure on your primary residents. And once you reach age 72, you must begin taking required minimum distributions or RMDs from a 401k. And the amount that you have to take out depends on the balance in your account and your life expectancy defined by IRS TA. So those are gonna depend on your age and your gender and any RMDs that were not previously taxed, do get included in your taxable income.
Now, another way that it’s possible to take money from a 401k is a loan. So this is another option, but only if you’re plan permits it, some plans don’t permit loans. So if this is something of interest, you’ll need to, to check with your plan to understand what the rules are, and while it can be tempting to borrow from yourself, especially as you accumulate bigger balances, I want you to be sure that you understand the rules for taking a 401k loan. So here are some points that you need to know. You typically must repay a 401k loan within five years and your loan payments will get deducted from your paychecks. And you’ve gotta repay interest on any 401k loans, even though you’re borrowing from yourself, you do have to repay it with interest. And that rule just makes sure that you’re making up for lost investment time.
And you cannot take a 401k loan that exceeds either $50,000 or 50% of your vested account balance. Whichever is less so $50,000 is going to be the maximum amount that you could borrow from yourself. And also note that you may get prohibited from making any new contributions to your 401k while you’re repaying loan. So that’s gonna leave you unable to enjoy investment growth and that valuable employer matching that we talked about. I mention that when I was just starting out, I was reticent to use a 401k, cuz I just wasn’t sure what would happen to that money if I left my job. So I wanna make sure you understand that if you leave your company for any reason, your money is going to be fine, however, you can no longer make any new contributions to an old and employer’s retirement plan. You know, you can still leave the money with the old employer.
If you like, you just can’t add any new contributions to it. However, it’s easy to take your vested 401k balance with you. So there are five things that you can do with your 401k when you’re leaving an employer, number one is to cash. Now that is the worst option. And I’ll explain more about that in a minute. The second option is just to leave it with your ex-employer. Now, you know, that may be okay if you came from a very large company or maybe even the government where you know that nothing is gonna happen to the plan. If you came from a small employer, you may wanna about taking that money with you instead of leaving it in the 401k with the, with the old employer, the third option is to roll it over to an IRA. The fourth option is to roll it over to a 401k with your new employer.
And the fifth option would be to roll it over into an account for the self-employed. So if you’ve got self employ limit income, or you left your job to go into business for yourself, that’s one option. Most people choose to do an IRA rollover with their old 401k. And that just gives you a lot more control over your investment options and the fees that you have to pay. But as I mentioned, if you’ve got a new job with a retirement planner, you become self-employed moving funds into a new 401k or into a new solo 401k. Those are also excellent options. But as I mentioned, the worst option for an old 401k is to cash it out because it is an early withdrawal. If you’re younger than age, 59 and a half. So as I mentioned for a traditional account, you’re gonna have to pay income tax plus that hefty 10% penalty leaving you with significantly less money.
And if you’ve got a Roth account, you are still gonna have to pay income. And that penalty on any portion of the account that was not previously taxed. All right? So let’s say your employer does offer a 401k. You may already be enrolled in your plan and not even know it that’s because many companies automatically enroll new employees to encourage your participation. In fact, you have to opt out of the plan, uh, versus opting into the plan and you can review your last paycheck or contact your benefits administrator if you’re not sure if you’re enrolled in a 401k at work, but if you’ve already got a 401k and you know, you know that you’re participating, you can simply log onto your online portal to adjust your contribu amount, choose investments and see your employer matching funds. Most plans offer a diversified investment menu. That includes investments like mutual funds, exchange, traded funds and money market funds.
Now another type of fund that you may see is called a target date fund. These have become really popular or in 401ks. They allow you to select a fund based on the date that you expect or want to retire. Then the fund automatically adjusts its underlying investments to be more conservative as the date of your expected retirement approaches. So it’s gonna be, be more aggressive when you’ve got lots of time before retirement, but it will slowly become a little bit more conservative as that target date approaches. And if you don’t understand your 401k investment choices, or you need a little help selecting appropriate funds for your financial objectives, I would highly encourage you to speak with a financial advisor and many, four OHK offer free advice or even low cost options if you do have to pay for it. But most plans that I’m familiar with actually have free advisors for all of the plan participants.
So that is a fantastic way to get some advice if you’re just not sure how to pick your funds in the account. And another real great feature of most 401ks is something called auto escalation. So this automatically increases your contribution rate over time, such as 1% per year until you hit a certain limit. So that’s an excellent feature for slowly building your savings rate over time. So if you are not already enrolled in auto escalation, I highly recommend it. As I mentioned, you could set it for 1% per year. You could set it really for, for anything that you like. Um, just make sure that every year you’re adding a little bit more you’re, uh, you’re saving and investing a little bit more than you were the prior year. So I wanna summarize some of the main advantages of using a 401k. I think a main advantage is that, you know, employers are offering free matching contributions as an incentive for you.
That free money is just unbe. Also they are gonna help you reduce your tax bill by making traditional 401k contributions. So remember the traditional accounts are made on a pre-tax basis and that allows you to have income in the current year. That is not taxed. And if you’ve got a Roth 401k, you’re gonna get tax free withdrawals in retirement. So you do have to pay the tax upfront with a Roth, but you’re gonna get to take withdrawals that are completely tax free. And if you’re not sure whether the traditional a Roth is for you, I would recommend going 50 50 put half of your contribution in a pre-tax account and half in an after tax account. That will also give you you different types of income in retirement. And another big advantage with a 401k is that you own your vested account balance and can take that money with you when you leave a job.
Now, let’s talk about some disadvantages of 401ks. One is that not all employers offer them. Uh, another is you typically cannot tap a 401k before age 59 and a half without paying an early withdrawal penalty, which is a 10% penalty. Another downside is that you may pay higher investment fees compared to other types of retirement accounts, such as an IRA. And that’s because 401ks have a lot of adminis of burdens. And so that’s typically passed on to investors and you may have fewer investment options with a 401k than with an IRA. However, some people see that as a benefit because it really streamlines their choices. All right, those are the main points that you need to know about 401ks. Now. Now let me turn to a couple of your questions. One came in from Justin C who says, do you recommend that I roll over an old 4 0 3 B with a past employer into my new 4 0 3 B at my new job.
My previous 4 0 3 B is through fidelity with returns over 14% per year to date. And my current active 4 0 3 B is through Lincoln financial. And isn’t returning quite as much. Thank you, Justin. This is a great question. You know, as I mentioned, I think, you know, there’s nothing wrong with leaving funds with an old employer. If you trust that that employer is managing the funds, uh, correctly. And you know, you’re happy with that old account and it’s possible that you may be able to get higher investment returns based on the funds that you choose in your new plan. You know, it may be, uh, simply that you’ve just got a different allocation of funds. So, you know, I would say there is some benefit to consolidating everything and just being able to know that it’s all in one place. So if that convenience, you know, is really worth something to you, I would say, go ahead and do the rollover.
If not, if you don’t mind managing two separate accounts and you’re really enjoying the fidelity account, I would say there’s nothing wrong with, with leaving it there. If you feel confident in that old employer, Justin, thank you so much for that question. And mark says, thanks so much for your great show. I’ve started investing over the past year and I’ve learned so much from listening to your podcast. I’m 28 years old and at the beginning of my career. So I would rather pay taxes now than in the future. When I assume I’ll be in a higher tax bracket, I have self-employment income from a side gig as well as income from a 10 99 job and a separate W2 job. I’m set to max out my Roth IRA for the year, soon after I do. So where should I invest any additional money in a regular brokerage account, a simple IRA, a SEP IRA, or a solo 401k mark, thank you for your kind words and great job on diversifying your income, uh, at such a young age.
That’s fantastic. So I would say it’s really been us to stick with the tax advantaged accounts. So if you can put that extra money into a SEP IRA or a solo 401k, those are the two that are only eligible. If you’ve got self-employment income, if you can, you know, max, either one of those out first, that’s gonna give you the most advantages because you’re gonna get tax benefit fits from them. Whereas if you go with a regular brokerage account, you know, you are gonna have, uh, you know, more tax liability there and the differences between the step IRA and the solo 401k really come down to whether you are gonna have employees or plan on having any employees in your business. So if you are, you know, just a one person, small business, you can have either the SEP IRA or the solo 401k. I’ve got a SEP IRA, even though I use contractors in my business and not employees, I chose the SEP IRA because I wanted to have the option to hire employees down the road.
So mark, I hope that helps again, just all always use the tax advantaged accounts first and then move over to taxable accounts. Before I let you go. I wanna invite you to join my free private Facebook group called dominate your dollars. It’s a fantastic group of people. All you have to do is search for dominate your dollars on Facebook, and you can also visit Laura adams.com where you’ll find my contact page and more about me, my books and online classes. That’s all for now. I’ll talk to you next week until then here’s to living a richer life. Money girl is a quick and dirty tips podcast. It’s audio engineered by Steve Berg with editing by Adam Cecil. Our operations and editorial manager is Michelle Marus. Our assistant manager is Emily Miller and our marketing and publicity assistant is Devina Tomlin.
Most people know they should save for retirement; however, using a 401(k) may seem too overwhelming or complicated and prevent many from getting started. When I was in my 20s, I didn’t invest in my company’s 401(k) because I wasn’t sure what would happen if I left my job. Not understanding the retirement account rules held me back, and I don’t want that to happen to you.
While 401(k)s come with critical IRS regulations you should know, they’re not as tricky to master as you might think. If you’re lucky enough to work for an employer offering a 401(k), participating can be a powerful way to build wealth for retirement.
In this guide, I’ll cover everything you need to know about 401(k)s, so you can accumulate a healthy nest egg and have a secure financial future.
What is a 401(k)?
In simple terms, a 401(k) is an employer-sponsored account for workers to save money for retirement. However, if you’re self-employed, you can have a solo 401(k).
The two main types are traditional and Roth. With a traditional 401(k), your employer (or you, if you’re self-employed with a solo 401(k)) deducts contributions from your paycheck before taxes get withheld and deposits them in your account. You defer paying tax on your deposits and investment earnings until you take 401(k) distributions in retirement.
With a Roth 401(k), your employer deducts contributions from your paycheck on an after-tax basis and deposits them in your account. While you must pay tax upfront on contributions, your withdrawals of deposits and earnings in retirement are entirely tax-free.
What is 401(k) matching?
One of the most valuable benefits of participating in a 401(k) is that your employer may incentivize you by paying a match, which is free money. For instance, your company could match 100% or 50% of your contributions up to a specific limit.
Let’s say you earn $50,000 a year and get a 50% employer match up to 6% of your salary. If you save $3,000 in your retirement account, your employer will deposit $1,500. That’s an instant 50% return on your investment. Not bad, right?
Now let’s say you get the full $1,500 match year over year for the next 30 years. You’d have an extra $127,202 in your account to spend in retirement. And that’s a conservative estimate because it doesn’t account for potential increases in your wages.
There’s one catch you should know about 401(k) matches: Some employers impose a vesting schedule. Vesting prevents you from owning matching funds until you’ve been employed for a set number of years. That means if you leave your job, you could forfeit some of all of your matching funds.
However, there’s never a vesting schedule for the contributions you make from your paycheck. You always own 100% of the funds you deposit in a 401(k) and can never lose them if you change jobs or get fired.
What are the 401(k) contribution limits?
For 2022, you can contribute up to $20,500 to your 401(k), or up to $27,000 if you’re over age 50. These limits have been increased by $1,000 from 2021.
Also, note that the annual contribution limit doesn’t include any employer matching. So, if you contribute $20,500 and your employer adds $2,500, it’s icing on the cake!
Can you take 401(k) withdrawals!
Since the purpose of a 401(k) is to invest for retirement, there are rules against taking withdrawals before age 59½. If you tap into your 401(k) early, you typically must pay income tax plus a 10% early withdrawal penalty.
However, there are penalty exceptions. For instance, the Rule of 55 says that you can take distributions penalty-free if you leave your job after age 55. That’s excellent news if you want to retire early. However, you still must pay income tax on withdrawals that weren’t previously taxed.
Additionally, you can skip the early withdrawal penalty for qualified hardships, such as becoming disabled, paying for education expenses, or avoiding foreclosure on your primary residence.
Once you reach age 72, you must begin taking required minimum distributions (RMDs) from a 401(k). The amount depends on the balance in your account and your life expectancy defined by IRS tables. RMDs that weren’t previously taxed get included in your taxable income.
Can you take 401(k) loans?
Another option to withdraw from your 401(k) is a loan—if your plan permits it. While it can be tempting to borrow from yourself, be sure you understand the following:
- You typically must repay a 401(k) loan within five years.
- Your 401(k) loan payments get deducted from your paychecks.
- You must repay interest on 401(k) loans to make up for lost investment time.
- You can’t take a 401(k) loan that exceeds $50,000 or 50% of your vested account balance, whichever is less.
- You may get prohibited from making new contributions while repaying a 401(k) loan, leaving you unable to enjoy investing growth and employer matching.
What happens to a 401(k) if you leave a job?
If you leave your company, you can no longer make any new contributions to your old employer’s retirement plan. However, it’s easy to take your vested 401(k) balance with you.
Here are five options you have for your 401(k) when leaving an employer:
- Cash it out.
- Leave it with your ex-employer.
- Roll it over to an IRA.
- Roll it over to a 401(k) with a new employer.
- Roll it over to an account for the self-employed.
Most people choose to do an IRA rollover with their old 401(k) to have more control over their investment options and fees. But if you have a new job with a retirement plan or become self-employed, moving funds to a new 401(k) or solo 401(k) are also excellent options.
The worst option for an old 401(k) is cashing out because it’s an early withdrawal if you’re younger than 59½. You’d have to pay income tax plus the hefty 10% penalty, leaving you with significantly less money.
How to start investing in your 401(k)?
If your employer offers a 401(k), you may already be enrolled and not know it! Many companies auto-enroll new employees to encourage participation. You can review your last paycheck or contact your benefits administrator for more information.
If you already have a 401(k), log on to your online portal to adjust your contribution amount, choose investments, and see your employer match. Most plans offer a diversified investment menu that includes mutual funds, exchange-traded funds, and money market funds.
Target date funds are a mutual fund type that’s become popular in 401(k)s. They allow you to select a fund based on the date you expect to retire. Then the fund automatically adjusts its underlying investments to be more conservative as the date approaches.
If you don’t understand your 401(k) investment choices or need help selecting appropriate funds for your financial objectives, speak with a financial advisor. Many 401(k)s offer free or low-cost guidance for plan participants.
What are the advantages of a 401(k)?
Here are several pros for using a 401(k) to invest for retirement:
- Many employers offer a 401(k) matching program that incentivizes you to save by making free contributions on your behalf.
- You reduce your tax bill by making traditional 401(k) contributions.
- You get tax-free withdrawal in retirement if you have a Roth 401(k).
- You own your vested 401(k) funds and can take them with you when you leave a job.
What are the disadvantages of 401(k)s?
Here are a few cons for 401(k)s:
- Not all employers offer a 401(k) retirement plan.
- You typically can’t tap a 401(k) before age 59½ without paying an early withdrawal penalty.
- You may pay higher investment fees compared to other types of retirement accounts, such as an IRA.
- You may have fewer investment options than with an IRA (however, some might see that as a benefit).
This article originally appeared on Quick and Dirty Tips.
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