A 401(k) is a tax-advantaged retirement account, usually offered through an employer. Employees may elect to defer a certain percentage of their paychecks to their 401(k)s, and employers often match some of these contributions.
The various types of 401(k)s differ in eligibility requirements and how they are taxed. Here's everything you need to know if you're thinking about contributing to a 401(k).
Benefits of a 401(k)
Placing your savings in a 401(k) confers many advantages. Here are some of the most important ones:
- Tax savings: Contributions to traditional 401(k)s are made with pre-tax dollars, which reduces your taxable income for the current year. The contributions are tax-deferred, which means that you instead owe taxes when you withdraw funds in retirement. If you are in a higher tax bracket today than you expect to be in retirement, then deferring the tax liability can save you money.
- High contribution limits: 401(k) contribution limits are much higher than contribution limits for Individual Retirement Account (IRAs).
- Employer match: Employers often match a percentage of their employees' contributions. This is like getting a bonus and reduces how much you need to save for retirement on your own.
- Automatic contributions: You can elect to defer a percentage of each paycheck to your 401(k), so that you don't have to make retirement contributions manually. You can also change your contribution percentage at any time.
- Rollovers: If you leave your employer, you may keep your retirement savings in your old 401(k) or roll over the funds into your new company's 401(k) or an IRA.
401(k)s are company-sponsored retirement plans, so as soon as you meet your company's eligibility requirements, you may enroll and decide how much of each paycheck you would like to contribute. Some companies automatically enroll employees in their 401(k) plans. Check with your company's HR department to learn more about your plan.
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When can I withdraw from my 401(k)?
Here’s a closer look at some of the rules that apply to 401(k) withdrawals.
You may take money out of your 401(k) at any time, but you will pay a 10% early withdrawal penalty if you do so before age 59 1/2, unless you have a qualifying exception. Qualifying exceptions include large medical expenses, educational expenses, and first-home purchases, among others.
Required minimum distributions
Required minimum distributions (RMDs) are mandatory distributions from 401(k)s that must begin when you turn 72. Before 2020, RMDs were required to begin at age 70 1/2. Calculate your RMD by dividing your 401(k) balance by the distribution period next to your age in this table. Failure to annually withdraw at least this much triggers a 50% penalty on the amount that you should have withdrawn.
Adults ages 72 and older who are still working may delay RMDs from their current 401(k) until they retire, though if they have any IRAs or old 401(k)s from former employers, they must still take their RMDs from these accounts starting at age 72.
Rule of 55
The Rule of 55 permits those who quit their jobs or are fired in the year they turn 55 or later to take penalty-free withdrawals from their 401(k)s even if they are younger than 59 1/2. Public safety workers are eligible for penalty-free distributions if they leave their jobs after they turn 50. You may take penalty-free distributions only from your most recent 401(k), not from other retirement accounts.
Some 401(k)s enable participants to borrow money from their plans and pay it back over time with interest. A 401(k) loan can for some people be a nice alternative to a traditional bank loan, but withdrawing funds could slow the growth of your retirement savings. If you are unable to pay back the full amount that you borrowed by the end of the loan term, the outstanding balance is considered a distribution and taxed accordingly.
What are 401(k) limits?
These are some of the key 401(k) rules and limits of which you should be aware if you plan to contribute to this type of account.
You may contribute up to $19,500 to a 401(k) in 2020 and 2021, unless you are age 50 or older, in which case you may make an extra catch-up contribution of up to $6,500. These contribution limits can change yearly.
People classified by the IRS as highly compensated employees (HCEs) -- those who own more than 5% of the company for which they work or earn more than $130,000 annually in 2020 and 2021 -- may not be eligible to contribute to their 401(k)s up to the maximum limits. Those in the top 20% of their company by income may also be classified as HCEs if their company chooses.
Employers must perform nondiscrimination tests annually to ensure that HCEs aren’t contributing significantly more money to their 401(k)s than non-HCEs. Long story short, average annual HCE contributions may not exceed non-HCE contributions by more than two percentage points. If they do, then HCEs are prohibited from contributing up to the annual limits outlined above.
If you’re married, you need your spouse’s written consent to designate someone other than your spouse as your 401(k) beneficiary. Otherwise, you may designate any person you like to inherit your 401(k) when you die, provided that there are funds remaining in the account. If you fail to designate a beneficiary, then the money usually goes to your estate.
Review who you’ve designated as the account’s beneficiaries at least annually. Divorce, birth or adoption of children, and deaths in the family can all necessitate a change in the existing beneficiaries.
Which type of 401(k) is best for you?
401(k)s come in several varieties. Most of the information above centers on tax-deferred 401(k)s, which are the most common. But other types of 401(k)s include:
|Roth 401(k)||This is much the same as a traditional 401(k), except that contributions are made with after-tax dollars. Contributions to Roth 401(k)s don't reduce your taxable income for the current year, but rather are distributed tax-free in retirement. Employers that offer matching programs cannot contribute directly to Roth 401(k)s, and must instead contribute any matching funds to a traditional 401(k).|
|Solo 401(k)||A solo 401(k) is available only to self-employed people. This type of 401(k) effectively has higher annual contribution limits because you can contribute as both employee and employer.|
|Inherited 401(k)||An inherited 401(k) is what a beneficiary receives when the original 401(k) owner dies. After the account is transferred, the beneficiary may not contribute any new money to this account and must withdraw it within a set number of years. If the original owner of the 401(k) was the beneficiary’s spouse, then the beneficiary may roll it over into his or her own 401(k).|
|Highly compensated employee 401(k)||This is not a special type of 401(k). HCEs may contribute to the same 401(k)s as non-HCEs, though, as explained above, how much they can contribute may vary.|
401(k) vs. other retirement accounts
Here's a closer look at how 401(k)s stack up against other common retirement accounts.