What is a 401(k)?
A 401(k) plan is an investment account with tax advantages that an employer can offer to its employees. The type of investments in a 401(k) vary by employer but usually fall into the categories of mutual funds (stocks and bonds), company stock, or guaranteed investments contracts (GIC). There are two types of 401(k) plans; a traditional 401(k) and a Roth 401(K). These 401(k) accounts are similar to Individual Retirement Accounts in terms of how they are taxed. If you have a traditional 401(k), the employee can make contributions by withholding a portion of their job income which also reduces a person’s taxable income for the year. A traditional 401(k) is taxed when you withdraw money from the account. A Roth 401(k) is funded with after-tax dollars resulting in the withdrawal of earnings being tax free. The maximum 401(k) contribution limit is $19,500 for an individual age 50 or younger. (irs.gov)
Employer Match
The employer can also make contributions to the 401(k) account of the employee. These contributions are known as an “employer match” and is practically “free money” for the employee in addition to their contributions. The match amount depends on the employee’s contributions and policy of the employer regarding 401(k) matching. According to humaninterest.com, the average employer match for a 401(k) is 4.7% of an employee’s salary.
When can I withdraw from the account?
Access to the funds in the 401(k) account becomes limited after the contributions have been made. An individual can start to make withdrawals from the account at age 59½ without a tax penalty. Since Roth 401(k) contributions are after-tax dollars, the contributions can be withdrawn tax free at any time. The earnings in the Roth 401(k) will be taxed though if withdrawn early. Once a person reaches age 72, they will be required in most cases to take minimum distributions (set percentage that IRS determines) from their 401(k) account.
What happens if I leave my employer?
You may be wondering what would happen to your 401(k) if you got another job or just ended up leaving your employer. The good news is that there are multiple options for handling your 401(k) when leaving an employer. You can rollover your 401(k) account into an Individual Retirement Account or move it to your new employer. Another option is for your 401(k) to remain with your old employer. The old employer generally will allow the 401(k) to remain with them if the account is not small but will likely not allow further contributions. The last option is to withdraw your money but this will result in a 10% early withdrawal penalty if the individual is under age 59½. Additionally, the traditional 401(k) funds will be taxed while only the earnings in the Roth 401(k) will be taxed.
Overall, 401(k) accounts can be another way to invest long term and the employer match is a unique advantage which can help you build more wealth in the long run.
Disclaimer: Thegrownwave.com is a personal finance blog, not a professional investment advisor. The content produced from the blog is provided for free and only for informational purposes. Thegrownwave.com does not and cannot promise the accuracy and reliability of any content in comparison to your individual circumstances.
Sources:
Fernando, J. (2021, August 2). What is a 401(k) plan? Investopedia. https://www.investopedia.com/terms/1/401kplan.asp.
Retirement topics – 401(k) and profit-sharing plan contribution limits. Internal Revenue Service. (n.d.). https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits.
Team, T. H. I. (2020, June 8). What is the average 401(k) employer match. Human Interest. https://humaninterest.com/blog/average-401k-match/.
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