If you're one of the many Americans eligible to participate in 401(k) retirement accounts, this savings option makes it easy to stash away funds for your financial future and possibly receive a company match during the process. A 401(k) can provide tax benefits and some flexibility in case you need the funds early. However, these plans do have some limitations and thus might not suit every retirement saver. Here's some important personal finance information to know about these accounts.
401(k) Retirement Plan Basics
A 401(k) lets you conveniently contribute funds from your paycheck toward your retirement. According to the U.S. Securities and Exchange Commission, there are traditional 401(k)s that use pretax earnings and defer taxes until withdrawal and Roth 401(k)s that use after-tax earnings and thus incur taxes upon contribution. You can pick from the different investments your company's plan offers, such as money market and mutual funds, and you may also have access to a brokerage account for more customization.
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If your employer offers matching contributions, you might get a percentage of your contributions up to a certain percentage of your salary, such as 6 percent. However, the IRS cautions that a vesting schedule can apply to employer contributions unless you have a safe harbor plan. Therefore, you could lose some or all of this free money if you leave the company before being fully vested.
You can make withdrawals from the 401(k) without a penalty once you turn 59 1/2 or if you qualify for a hardship exemption. If you leave your job first, you might opt to leave the plan where it is, do a rollover or just cash it out early with the penalty. In addition, mandatory minimum withdrawals begin at age 72.
Why Invest in a 401(k)?
A 401(k) retirement savings account offers the advantage of a high annual contribution limit compared to an individual retirement account (IRA). The IRS says you can contribute up to $20,500 in 2022 plus an extra $6,500 in catch-up contributions to your 401(k) if you're 50 or older. You can benefit from any matching contributions too. At the same time, having a 401(k) doesn't disqualify you from having a traditional or Roth IRA or a regular brokerage account for more investment options.
Tax benefits make a 401(k) appealing and vary for traditional versus Roth accounts. Contributing to a traditional 401(k) with pretax dollars lets you lower the taxable income now since you'll pay taxes when you withdraw the funds later. Roth 401(k) accounts, on the other hand, require paying taxes on contributions now, but you can enjoy tax-free retirement withdrawals, even on your earnings.
You can also benefit from having some emergency access to the funds before retirement, but rules vary by plan provider. FINRA mentions you might be able to withdraw funds early for reasons such as experiencing significant medical expenses, disability or urgent housing needs. However, some reasons don't exempt you from the 10 percent penalty, and you can also end up paying income taxes. Your provider might alternatively allow 401(k) loans where you make payments with interest for five years on the borrowed amount.
A 401(k) can provide tax benefits and some flexibility in case you need the funds early.
What Are 401(k) Limitations?
While 401(k)s are appealing, be aware of some downsides. For example, not all companies match your contributions or offer the types of investments you'd like to see in your 401(k), so you might prefer to invest directly in the stock market. The U.S. Department of Labor also cautions about the 401(k) plan fees that can add up and cut into your earnings.
In addition, consider the income taxes on distributions so that you're prepared. The tax advantages of a traditional 401(k) now mean paying taxes later in retirement when you may or may not fall in a higher tax bracket. In addition, if you need an early withdrawal, the 10 percent penalty plus the taxable income created can create a financial hardship.
Is a 401(k) Worth It?
You'll want to think about your financial needs to decide whether a 401(k) is worth it. You should check with the plan administrator to learn about investment options, any employer match and allowances for loans and hardship withdrawals. If you think you might have a higher tax rate at retirement age, you might inquire about Roth 401(k)s. It also helps to meet with a financial planner who can help you make investment decisions based on your retirement income needs, age and risk tolerance.