What’s a 401(k) Plan? (The simplified explanation)
It’s a retirement plan that is employer-sponsored. A set percentage of your paycheck (that you choose) gets automatically taken out of your check. That goes into your 401k account, which then gets invested in whatever you choose (for example: stocks, bonds, mutual funds, etc). Depending on where you work, your employer will also match what you put in, anywhere from 50% to 100% of what you put in.
Benefits of a 401(k) Plan
1. Money inside a 401k account is tax-free, you don’t pay taxes on it until you withdraw it when you retire.
2. 401k contributions are not counted as income. This allows you to be put in a lower tax bracket.
3. Money compounds in a 401k account, without you having to pay tax on any earnings.
4. Money in a 401k is sheltered from creditors by the Employee Retirement Income Security Act of 1974 (ERISA), meaning they can’t come after it.
Are all 401(k) plans the same?
No, each employer will set the terms of their plans. Some companies will offer to match 50% of your contribution amount, while others will do a 100% match. That means that if you put $5000 into your 401k plan this month, they’ll also put in another $5000.
What is a Roth 401(k) and how is it different?
The Roth 401(k) started in 2006. The difference is that the amount you contribute still gets counted as income, so you won’t be able to lower your tax bracket. However, you won’t have to pay tax when you withdraw the funds after retirement.
What if I change jobs/employers?
If you change jobs, you can transfer your 401k account into your new one with your new employer.
You could also decide to keep your funds with your previous employer indefinitely if they offer better investment choices. However, you will not be able to make any further contributions.
The last option you have would be to cash out your current 401k plan, but this will count as cashing out early and you’ll have to pay taxes and penalty fees.
What age can I cash out my 401k account?
The earliest you can withdraw from your 401k account without paying any penalties is age 59.5. You will still be required to pay tax on the amount you withdraw.
What is the penalty for withdrawing early?
10% of the amount you withdraw. This is considered a huge penalty and you should avoid this at all costs.
How long can I keep my 401k account?
The IRS will begin to force you to take distributions from your 401k account once you turn 70 years of age.
What is the maximum 401k contribution amount?
If you are under 50 years of age, the maximum 401k plan contribution amount is $19,500 per year.
If you are over 50 years of age, the maximum 401k plan contribution amount is $26,000 per year. (The IRS allows for an additional $6,500 contribution per year to help people prepare for retirement).