The prospect of retiring may seem outlandish for many millennials and anyone else affected by the recession, but truthfully, retirement can be a reality for anyone who saves successfully. To continue our saving theme, today I’m going to discuss the 401(k) plan and how you can utilize it to better your retirement future.
The 401(k) is perhaps the most well-known retirement savings account and is usually the first topic in the retirement discussion. It’s also well-used: In September 2017, 401(k)s made up $5.3 trillion of the retirement assets in the United States.
The name 401(k) comes from the Section 401 of the Internal Revenue Code and the subsection (k) that refers to this specific characteristic of a profit-sharing plan that is sponsored by an employer. The 401(k) came about in 1978 to supplement the waning existence of employer pensions.
How does it work?
The selling point of 401(k) plans is the fact you can contribute a percentage of your paycheck before taxes to an investment account. The key words here are before taxes. However, the money will be taxed when it is withdrawn.
Most plans offer a variety of investment options for the employee to choose from. They are generally composed of mutual funds and target-date funds.
What makes 401(k) plans even more attractive are the employer contributions and profit-sharing features. After you’ve been with a company for a certain time, they begin matching your contributions up to a certain percent. It’s also possible a profit sharing plan will be linked to a 401(k). This means the employer has the option to invest company money on behalf of their employees. This is separate from 401(k) employer matching.
Limits to 401(k)s
There are also limits to 401(k)s. In 2018, employees who participate in 401(k)s are limited to contribute $18,500 to their plans. Also, the total amount contributed from both you and your employer cannot equal more than your salary or $55,000 (in 2018).
Another aspect to 401(k)s is the limited access you have to your money. For example, you can’t access your funds before age 59½. If you take money out early, you’ll receive a 10% penalty on top of the basic tax at withdrawal.
However, eventually you have to start taking your money out. Uncle Sam allows you to grow your money tax deferred on the condition he can eventually exact his toll. Generally, you have to start taking out withdrawals by the time you reach age 70½. These are called required minimum distributions (RMDs). Your RMD depends on your account balance and life expectancy. If you don’t start taking out RMDs when you’re supposed to, you can incur a 50 percent penalty on your distributions—if your RMD is $4,000 and you don’t make a withdrawal, you will lose $2,000.
Depending on your tax rate at retirement, the tax at withdrawal can come back to bite you. If your tax rate is higher than it was when you were making contributions, then you’ll end up paying more in taxes.
Some alternatives to paying taxes on your retirement like this are the Roth 401(k) or Roth IRA, which we’ll discuss next time, so stay tuned.
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