.jpg)
Your retirement may seem like it’s far away, but the reality is that you won’t be able to enjoy it unless you start planning for it now. The earlier you begin saving and investing, the more time your money will have to grow into something substantial before you ever retire. Thankfully, even if you’re young and just starting out, there are still plenty of tax-advantaged ways to save, including a 401(k) plan—but how exactly does a 401(k) work? We’ve got all the answers here.
What is a 401(k)?
A 401(k) is an account offered by your employer that allows you to save money for retirement on a tax-deferred basis. This means you don't pay taxes on money that goes into your account. You also don't have to pay taxes on any earnings until they are withdrawn in retirement, so you can enjoy tax-deferred gains over time. In addition, if your employer matches employee contributions, it's free money—you're getting paid before even making it yourself! It doesn't take much time or effort, and it's very beneficial in helping put you in control of your financial future.
How does a 401(k) work?
The 401(k) is an employee-sponsored, tax-deferred retirement plan. These plans are sometimes called defined contribution plans because they set out specifically how much an employer will contribute, and how much employees will put in from their paychecks. They were developed as an alternative to pension plans, which were based on promises of lifetime income after employees retired. Because pensions weren't portable when workers switched jobs, companies began offering defined contribution retirement plans that let workers invest money for their own futures. The contributions into such accounts aren't subject to current taxes and employers don't pay taxes on contributions until those funds are withdrawn from the account at retirement. Nowadays there are many different types of 401(k)s offered by companies, but all share some common elements and benefits
Things to consider when investing in your 401(k)
What’s most important? How much money you save, how often you save, or how long you have until retirement? Those three factors influence your savings rate, and it all adds up. In fact, sometimes even small changes can make a big difference in total dollars saved. Take that into account when deciding whether it makes sense to skip that latte or not. It's best to save up as much as possible when you're young, even if your income rises later in life.
The future of the individual 401(k)
The Individual 401(k) (I-401(k)) is an alternative to a traditional self-directed Individual Retirement Account (IRA). Like an IRA, contributions are made with pre-tax dollars, but unlike an IRA, I-401(k)s can be used for non-retirement expenses. These plans typically come with high fees, so you'll want to make sure your contributions are large enough or invested wisely enough that they're worth it. Generally speaking, investors have three options when it comes to retirement: defined benefit plans (e.g., pensions), defined contribution plans (e.g., IRAs and 401(k)s), and individual retirement accounts and small business owners can get in on those tax benefits by establishing and funding their own Individual 401(k) plan. However, the Individual 401(k) is only available if you are the sole owner and beneficiary of your business. If you have employees, you don't qualify to have an I-401(k).
When to take money out of your 401(k)
First, know that you can withdraw money from your 401(k) at any time without incurring taxes or penalties—there’s something called hardship withdrawal. But if you can avoid it, don’t take money out of your account before you retire: The money will be taxed and potentially subject to an early-withdrawal penalty. (The IRS has more details on what constitutes a hardship.) And if you are retired and do have to tap into your retirement savings, try not to take more than 4%-6% in one year. Certainly, don't take more than 10%; otherwise, you may trigger what’s known as substantially equal periodic payments (SEPP), which are designed to prevent retirees from taking all their money out at once.