Ultimate Guide to
401(k)
Plan your way to a successful retirement
1. Introduction
Welcome the the Juno Guide on the 401(k)- The humble 401(k) has been a cornerstone of retirement planning for decades. If you’ve ever been gainfully employed, there’s a good chance you’ve had the opportunity to invest in one.
- But many people avoid taking advantage of their employer-sponsored 401(k) out of fear. If you don’t understand the basics - what it’s for, how it works and how to get the most out of it - you probably won’t be motivated to contribute money every month.
- That’s why we put together the Ultimate Guide to the 401(k). Here’s everything you need to know, from the trivial to the tricky.
2. What Is a 401(K)?
A quick-fire introduction to get you started- A 401(k) is an employer-sponsored retirement plan available to full-time and part-time workers. Sometimes, companies will even provide interns with 401(k)s.
- Like health insurance payments, 401(k) contributions are made through payroll deductions. Instead of manually contributing money to a 401(k) as you would with a savings account, the funds are withdrawn automatically through your paycheck.
- As of 2020, annual contribution limits are $19,500 with an extra $6,500 for anyone 50 or older. These amounts usually increase every year to keep up with the cost of living.
- There are certain tax advantages to investing in a 401(k) compared to a brokerage account, which vary depending on the type of 401(k).
3. What Are the Benefits of a 401(K)?
Advantages of an employee-sponsored retirement plan- Since their inception in 1980, 401(k)s have been a popular investing vehicle, especially since company pensions have mostly been eliminated.
- #1: Employer Contributions
- Employers are allowed to contribute to their employees’ 401(k) accounts. The total for both worker and employer contributions may not exceed $57,000 per year or $63,500 for employees over 50. These limits usually increase every year.
- Most companies contribute based on a dollar-per-dollar matching program. In 2019, the average employer contribution was 4.7%.
- Many employers base their contributions on how much employees contribute to their account, matching some or all of the amount. An employer may contribute up to 6% of your salary in a given year, for example, but only if you contribute at least that much. If you only contribute 4%, they’ll only contribute 4%. If you contribute 10%, they’ll still only contribute 6%.
- Employer contributions are a huge part of why 401(k)s are so popular. If you were already planning to invest in a retirement account, it’s essentially free money.
- The only catch is that you may not be immediately eligible to receive the full employer contribution. Some companies require employees to work there for a certain length of time before they become 100% eligible.
- This is determined by a vesting schedule, which dictates how quickly you earn the full employer contribution. Employers use vesting schedules to increase worker retention and prevent high turnover.
- Some companies have a graded vesting schedule, where you earn an equal percentage every year until you become 100% vested. A graded vesting schedule is usually between three to five years. In a three-year vesting schedule, you would earn 33% of the employer contributions each year.
- Other companies have a cliff vesting schedule, which requires that you work a certain number of years before you become eligible for any of the contributions. If you work for a company with a five-year cliff vesting schedule, you won’t receive any employer contributions if you leave before your five-year anniversary.
- Always ask about the vesting schedule when comparing employer benefits. If you don’t plan to stay for the full duration, the employer contributions will have little or no value.
- Companies are allowed to change their contribution amounts, sometimes increasing them as profits increase or decreasing them when sales are down.
- #2: 401(k) Loan
- You can borrow against the money in your 401(k). When you repay the loan, the interest and principal will go directly back into your 401(k) account. The interest rate will be similar to rates on other types of loans and will reflect market rates.
- You can usually borrow the lesser of $50,000 or 50% of your total balance. Some employers may also have a minimum threshold required for the loan.
- You usually have around five years to repay the loan, but this depends on your employer’s specific rules. However, if you quit your job, are laid off or fired, you’ll have to repay the loan within 90 days.
- Taking out a 401(k) loan is not a good idea if you plan to leave soon or if the company isn’t financially stable. If you’re laid off, the last thing you want to worry about is how to repay a large sum within 90 days.
- If you can’t repay the loan, then the money borrowed counts as an early 401(k) withdrawal. If you’re younger than 59.5, you’ll have to pay a 10% early withdrawal penalty and income taxes.
- Another downside to a 401(k) loan is that the money you borrow isn’t invested, and therefore won’t continue to grow in the stock market. Frequently borrowing large sums from your 401(k) could significantly impact your retirement timeline.
- #3: 401(k) Hardship Withdrawals
- If you’re going through a financial emergency, you can sometimes withdraw money from a 401(k) and avoid paying the 10% penalty. This is only available in rare cases, which may include:
- • Divorce
- • Permanent disability
- • Medical expenses exceeding 7.5% of your adjusted gross income
- • Being a reserve member of the military who’s called up to active duty
- If you’re not approved for the penalty waiver, your only option is to take out a 401(k) loan or withdraw the money and pay the penalty.
- #4: Required Minimum Withdrawals
- Both traditional and Roth 401(k)s have required minimum withdrawals (RMD)s. These are mandatory withdrawals that every account owner must take after age 72. The RMD amount varies annually depending on your account balance and age. You can contact the plan provider each year to see what your RMD amount is.
- The only exception is if you’re still working and the 401(k) is with your current employer. If you have a 401(k) with a previous employer, you may still be required to take the RMD.
4. What Are the Different Types of 401(K)S?
Breaking down retirement plans- While most people have a traditional 401(k), there are several variants with their own specific benefits. Here’s a rundown of each 401(k) type.
- What is a Traditional 401(k)?
- A traditional 401(k) is the original and most common type. One of the biggest benefits to having a traditional 401(k) is getting a tax deduction. Tax deductions decrease your taxable income which reduce how much you owe in taxes. If you’re used to owing taxes at the end of the year, contributing to a traditional 401(k) could ease that burden.
- Employees can deduct contributions from a traditional 401(k) on their taxes but will have to pay taxes on withdrawals when they retire. You can only deduct your own contributions and not your employer’s.
- In general, those in higher income brackets benefit most from a traditional 401(k) because they’ll see the biggest tax savings.
- What is a Roth 401(k)?
- Unlike a traditional 401(k), you can’t deduct Roth 401(k) contributions on your taxes. You will, however, have tax-free withdrawals after age 59.5. This is very similar to a Roth IRA. Roth 401(k)s are popular with younger workers and those in lower tax brackets because they won’t yet benefit from the tax deduction on withdrawals.
- What is a Self-Employed 401(k)?
- Freelancers and other self-employed workers can open Self-Employed 401(k)s, also referred to as Solo 401(k)s or individual 401(k)s. These are a solid alternative to IRAs, which have lower contribution limits.
- As a self-employed investor, you can contribute both as the employee and as the business owner. As the employee, you can contribute the $19,500 maximum annual limit. As the employer, you can contribute 25% of your total compensation, up to $57,000 total.
- This is why Self-Employed 401(k)s are objectively better than IRAs, which currently have a $6,000 maximum.
- What is a SIMPLE 401(k)?
- Businesses with less than 100 employees can offer SIMPLE 401(k) plans, which are often less expensive to set up than standard 401(k)s.
- There are only two ways an employer can contribute to a SIMPLE 401(k). They can either contribute 2% of an employee’s salary without requiring them to make any contributions themselves, or they can match up to 3% of the employee salary.
- Employees with a SIMPLE 401(k) are immediately 100% vested, so all employer contributions are theirs.
- Unfortunately, the contribution limits to a SIMPLE 401(k) are much lower than a regular 401(k). In 2020, the limit was $13,500 with a $3,000 catch-up contribution limit for those 50 or older.
5. How to Cash out a 401(K)
Exiting your retirement savings plan- Cashing out a 401(k) is a simple process. First, contact your 401(k) provider and tell them you want to close the account.
- If you’re younger than 59.5, be prepared to pay taxes and a 10% penalty on any money withdrawn. You should look at your current tax rate and save that amount, plus the 10% fee, in a separate account for tax time.
- It is generally advisable to never withdraw from your 401(k) and to treat it as a financial safety net. However, if you’re thinking of liquidating your 401(k) to purchase large assets like a property, we’ve compiled more targeted advice for you here.
6. The Difference Between an IRA vs. A 401(K)
Comparing and contrasting individual retirement accounts vs employee-sponsored ones- IRAs and 401(k)s often get lumped together because they are both types of retirement accounts.
- An Individual Retirement Account (IRA) can be opened through a bank or brokerage firm by anyone with an income. Unlike a 401(k), you don’t have to go through an employer to open an account.
- Many people open IRAs because their company doesn’t offer a 401(k) or doesn’t have a matching program for contributions.
- IRAs have much lower contribution limits than 401(k)s. In 2020, the annual contribution limit for an IRA is $6,000 with $1,000 extra if you’re 50 or older. That’s much less than the current 401(k) limit of $19,500 with an extra $6,500 allowed for those 50 or older.
- The biggest benefit an IRA has over a 401(k) is total freedom when selecting funds. With a 401(k), you’re limited to the funds that your employer provides. Some companies have a wide variety of low-cost funds, but others have a small mix of funds with high fees.
- If you have an IRA, you can open it wherever you like and choose the funds you want. You can open an account with a robo advisor or directly with a brokerage firm. Because an IRA isn’t tied to your employer, you don’t have to make any changes when switching jobs.
- Roth 401(k)s have required minimum withdrawals (RMD), but Roth IRAs don’t. Fortunately, this difference doesn’t matter until you reach retirement age. At that point, you can roll over the Roth 401(k) into a Roth IRA and avoid taking RMDs.
- Should I open an IRA or a 401(k)?
- Thankfully, the IRS allows consumers to open both an IRA and a 401(k) - with one exception.
- If you have access to a 401(k), you may not be allowed to deduct all of your traditional IRA contributions. This depends on your income, and the limits change every year. If your company offers a 401(k) and you also contribute to a traditional IRA, make sure that you understand if your contributions are tax-deductible.
- In 2020, those filing single or head of household with an income of $75,000 or more can’t deduct any IRA contributions. Those who are married filing jointly or a qualifying widow/widower with an income of $124,000 or more cannot take a deduction. The income limit is $10,000 for those married filing separately.
7. 401(K) Frequently Asked Questions
Everything you’ve ever wanted to know about the 401(k)- How do companies invest in 401(k)s?
- Every company can choose its own 401(k) provider and which funds they provide. Some companies have low-cost funds, while others may only offer funds with high fees. If you’re comparing job offers from multiple companies, ask to see their 401(k) fund options.
- Should I open a Roth or traditional 401(k)?
- Up until a few years ago, you could only open a traditional 401(k). You could have a Roth or traditional IRA, but 401(k)s did not have a tax-free option. Now that you can have either a Roth or traditional 401(k), it’s harder to decide which one to open.
- A basic rule of thumb is to open a Roth 401(k) if you anticipate having a higher income in retirement than you do now. This usually applies to workers who haven’t reached their peak salary. If you think your income is higher now than it will be in retirement, it’s probably better to choose a traditional 401(k).
- It’s hard to know what future tax laws will look like, so one strategy is to open both types of 401(k)s and split your contributions equally between them. Just make sure that your total contribution stays below the annual limit.
- Contact a financial planner if you want another point of view. They may have more insights on how to pick a 401(k) and how much to contribute.
- How much should I contribute to a 401(k)?
- In general, you should save between 10% to 15% of your salary for retirement. How much of that should go into a 401(k) vs. an IRA depends on several factors.
- First, look at your company’s matching program. If they match 100% of your 401(k) contributions up to the annual limit, then you should contribute as much as possible. Always contribute enough to get the employer contribution, because it’s essentially free money.
- Once you’ve reached that amount, you can decide whether it makes sense to save more. If you can, look at your 401(k)’s fund options. You should also see what the fees are. If they’re high, you should consider talking to HR about finding a less expensive option.
- How do I roll over a 401(k) to an IRA?
- Rolling over a 401(k) to an IRA is a fairly straightforward process. Many brokerage firms have direct rollovers where the money switches from the 401(k) to the IRA. Those that don’t have this option will send you a check with the rollover amount.
- If that happens, you have 60 days to transfer the money into a qualifying account or it will count as a 401(k) withdrawal. That means you’ll have to report it on your taxes and pay an extra 10% early withdrawal penalty.
- Once the money is rolled over to an IRA, you’ll have to select how you want to invest the funds.
- How do I roll over a 401(k) to a new employer?
- The first step is to set up a 401(k) with your new employer. Once that has been established, you can contact the old 401(k) provider and initiate a direct rollover.
- Again, not every brokerage firm may apply this. Some 401(k) providers may also require that you roll over at least $5,000. If you have less than that, you’ll have to leave the money with your old provider or transfer it to an IRA. For a more detailed guide, check out our piece on rolling over a 401(k).
- Why should I roll over my 401(k)?
- You’re usually not required to roll over a 401(k), but there are some drawbacks to not moving it. First, you can’t take out a 401(k) loan from an account held with a former employer.
- Also, some 401(k)s have high fees. If possible, you can save thousands of dollars - or more - by switching to a low-cost provider. If you do roll over a 401(k), you’ll have more investment options than you would otherwise.
- It’s also common for people to forget they have a 401(k) if they don’t roll it over. Having as few retirement accounts as possible simplifies your finances.
- Can I open a 401(k) if I’m not a US citizen?
- Employees of US firms who are not citizens are allowed to open a 401(k), but they still have to follow the same rules, limits and regulations as other employees. They may also have to pay the 10% early withdrawal penalty and taxes if they cash out before 59.5.
- How do I manage my 401(k)?
- After you’ve opened your 401(k), it’s time to pick which funds to invest in. You can usually choose from a variety of mutual funds or exchange-traded funds (ETF).
- Some companies will have a representative from the 401(k) provider advise you on which funds to choose.
- Target-date funds are mutual funds that automatically rebalance as you get older. Investors choose a target-date fund that closely matches their expected retirement date, usually offered in five-year increments. For example, a 25-year-old may choose a 2060 target-date fund if they want to retire at 65 years old.
- If you want more guidance, you can hire a financial planner to walk you through which funds to choose.
- It’s a good idea to check your 401(k) at least once a quarter to make sure that your contributions are going through. Some people will also rebalance their portfolio once a quarter or annually.
- Rebalancing entails selling off some funds to maintain an appropriate mix. If you have 20% of your 401(k) in bonds and you want to have a 10% mix in bonds, for instance, you may sell off half of your bond funds.
- Should I invest in a 401(k) if I don’t have much money?
- Some consumers think it’s pointless to save money for retirement if they can’t afford the recommended 10-15%. In reality, even a small savings rate early on can have a drastic effect on your retirement timeline. This is due to the magic of compound interest.
- With compound interest, every dollar saved earns interest. That interest is then added to the principal, allowing for even more interest to be earned. This compounding means that time is possibly the most important factor in growing your nest egg.
- If you can save $25 a month, that $25 will grow to $66,172.43 in 40 years with 7% interest. If you wait five years to start saving, you’ll end up saving $20,805.47 less.
- It’s even more important to save in a 401(k) if you receive a company match. Every dollar in employer contributions is free money you won’t be able to get anywhere else. Even if you can’t afford to contribute enough for the entire employer contribution, you should still save as much as you can.
Your Money, Simplified.
Earn up to 5% on deposits & 5% cashback on top brands like Amazon and Target
Create a free checking account within 5 mins
Juno (CapitalJ Inc.) is a financial technology company, not a bank. Banking services provided by Evolve Bank and Trust, Members FDIC. The Juno card is issued by Evolve Bank and Trust, Member FDIC, pursuant to license by Mastercard International.
© Copyright 2023 Juno by CapitalJ, Inc