Does your employer offer a 401(k) retirement plan? One of the most commonly used retirement plans available, a 401(k), lets you direct a portion of your income to your retirement savings regularly. It may not be sufficient for supporting all your needs once you retire, but it’s a start. In this article, we will discuss what is a 401(k) and how it works. Let’s begin.
What Is a 401(k) Retirement Plan?
A 401(k) plan is a type of retirement savings and investing plan. It gets its name from a portion of the US Internal Revenue Code and is offered by many employers. Employees can make contributions to their 401(k) retirement account through an automated process that withdraws a certain amount from their monthly paycheck and deposits it into the retirement account. Employers can also match the contributions made, and the money is invested in funds chosen by the employee. Employers usually provide a list of available funds to choose from.
Besides helping you save for retirement, 401(k) plans provide a tax break to employees. They don’t have to pay taxes on the money they contribute to the retirement account. The retirement savings in a typical 401(k) retirement plan won’t be taxed until the employee starts withdrawing money from the account. This usually happens after retirement. If you sign up for a Roth 401(k) plan, then you won’t be taxed on any withdrawals, as well.
Are There Any Limits To the Contributions You Make?
Now that you know what is a 401(k) let’s take a look at some of the rules associated with these types of accounts. For starters, given the tax benefits of a 401(k), you may be compelled to direct a significant portion of your income to a 401(k) retirement account. However, you need to be mindful of the contribution limits here.
As of 2021, the maximum contribution you can make to a traditional or Roth (401)k plan is $19,500. If you are of 50 years of age or older, then you can also make additional contributions of up to $6,500 to your account. These are known as catch-up contributions.
There are also additional contribution limits in place for high-wage earners. These individuals can only consider the initial $290,000 of their income when they calculate their maximum contributions to a 401(k).
What Are the Rules for Withdrawing Money From a 401(k) Plan?
Besides contribution limits, there are other rules that guide withdrawals from a 401(k) retirement plan. Let’s take a look at what these are:
When Can You Withdraw Money from Your Plan?
Typically, you are allowed to receive payouts from a 401(k) plan once you are 59½ years old. Withdrawing money before you reach this age can expose you to a tax penalty of 10%. That said, there are a few exceptions that allow you to withdraw money from your retirement account. These include retiring from or leaving your job, suffering from a disability, and experiencing hardships that have been pre-defined under the plan. You can also withdraw money from this account if the 401(k) plan gets terminated.
Besides this, if the account owner dies, then their beneficiaries can also withdraw money from the account without having to pay a tax penalty.
Can You Roll Over a 401(k) Plan?
401(k) plans often offer a limited number of investment choices that prevent your savings from growing in value. As a result of these limitations, some retirees prefer to transfer the money in their 401(k) retirement account to an IRA (Individual Retirement Account) or a Roth IRA. These accounts offer more flexible investment options that can help boost the value of your savings.
Transferring the balance of your 401(k) account to another retirement account is known as a rollover. If you plan to use this option, we recommend doing a direct rollover. This allows you to transfer the money directly to your new IRA account, and you won’t be subjected to taxes.
If you do an indirect rollover, then you will be withdrawing the money from your 401(k) account first and then depositing it into your IRA account. Indirect rollovers require you to pay taxes on the full balance withdrawn, which can be very expensive.
Can You Borrow a Loan from a 401(k) Retirement Plan?
If your employer gives you permission, you can also borrow a 401(k) loan. This option lets you borrow up to 50% of the current balance present in your 401(k) account. Normally, the maximum loan amount you can borrow here is $50,000.
Depending on the purpose of the loan, you are required to repay the borrowed amount within 5 years. This period can be extended with the loan was borrowed for buying a home. Compared to traditional loans, a 401(k) loan offers several advantages. For starters, you don’t have to worry about a credit check. The interest rates on these loans are usually lower than other loan types too. However, you may have to pay additional fees. If you quit your job before the loan is paid, then you are required to make complete payment within 90 days if you leave.
It’s important to note here that the maximum loan amounts for a 401(k) loan were increased in 2020. They were doubled under the CARES Act. It allowed people affected by the COVID-19 pandemic to borrow up to $100,000 from their 401(k) plan.
Wrapping It Up
We hope this blog proved useful in helping you understand what is a 401(k) plan. This type of retirement account is highly advantageous for employed individuals, as it allows them to build upon their retirement savings. Even if you have trouble saving up at the end of the month, you can rest easy knowing that an automatic contribution was made to your 401(k)plan. Having your employer match this contribution is very beneficial, as well.
The tax advantages of a 401(k) retirement account also add to its appeal. The contributions you make help reduce your taxable income. You also don’t have to pay taxes on any investment gains you make on your money.
If you don’t have a 401(k) plan yet, speak to your employer about it and ask if they offer one. Good luck!
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