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How does a 401k work? What you need to know for retirement planning

Updated: Feb 28, 2022

Utilizing a 401k plan can really help with retirement. Here's what you need to know for retirement planning with a 401k.

For many Americans, a 401k is the key to their retirement planning. Still, many workers don't understand how these plans work. To make sure you're prepared, we've outlined some important information about 401k plans.

Investing in a 401k

To invest in a 401k, you need to work at a company that offers one, or be the sole proprietor of a business (with no employees) and participate in an individual 401k. You can't open a 401k if you are unemployed. Once you're in a company-sponsored 401k, you might receive a matching contribution from your employer. For example, a 401k plan might let you invest a percentage of your salary each year and your company would match 50 cents for every dollar you add to your account up to three percent of your salary. The company match is free money, and it's usually a good idea to contribute at least up to the full percentage of the match.

401k contribution limits

Your company will tell you the maximum percentage of your salary you can add to the 401k each year. In most cases, this limit will be the same as the IRS limits. As of 2018, you can add up to $18,500 a year to your account if you are younger than 50 and up to $24,500 if you are 50 or older.

401k tax benefits

The money added to your 401k can be deducted from your taxable income. This helps you tackle two important financial goals: saving for the future while also bringing down your current tax bill. Many plans now also offer a Roth option that allows you to make after-tax contributions into your plan. However, any matching contributions will still be coded as traditional contributions; this means that a portion of each withdrawal that you make will be taxed as ordinary income proportionate to the amount of your elective deferrals versus the matching contribution.

Once your money is in a 401k, you'll be investing it in a variety of stocks, bonds, mutual funds and other investments. Typically, when you invest, you need to pay taxes on your investment earnings right away. Not with the 401k. As long as you keep your savings in this account, you can put off paying taxes on these gains until retirement.

Taking money out of a 401k

The 401k is a retirement plan, which means that you are discouraged from taking withdrawals out of the plan before you reach age 59 ½. If you leave your job, you can start taking penalty-free withdrawals from your 401k as soon as you turn 55. If you keep working past this age, you can start taking penalty-free withdrawals once you turn 59½. All distributions from traditional 401(k) plans are taxed as ordinary income.

When you take a retirement withdrawal, you'll need to pay income tax on that amount.

401k early withdrawals

Taking money out of your 401k before retirement can be difficult. First, your company plan needs to allow early withdrawals. Then, it gets expensive. The IRS charges an extra 10 percent penalty on top of income taxes on early 401k withdrawals. The penalty can be avoided in a few situations, such as paying for excess medical bills.

You might also be able to take money out as a loan. When you take out 401k loans, you won't owe taxes or a penalty provided you pay the money back into your plan with interest. Once again, whether you can take a loan depends on your company's 401k withdrawal rules. If you become unable to repay the loan, then the outstanding balance will be coded as a distribution and subject to early withdrawal penalties.

401k rollover when leaving your company

If you leave the company offering the 401k, you won't be able to add any more money to its plan. In this situation, it might make sense to take your retirement savings out the door with you, through an account rollover. When you roll over your old 401k, you transfer the account straight into another retirement plan, like an IRA or your new job's 401k, if allowed by your new employer. You typically won't owe any taxes on the move and can get right back to work investing as normal.

Managing a 401k takes some work but for most people, it's an important piece of saving for retirement. If you have questions about this financial tool, consult a financial advisor.

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