The Complete Guide to 401(k) Plans and Why You Should Have One Now


What is a 401(k) Plan?

A 401(k) plan is a retirement savings account that you can use to build up money for your future. It was designed by the government to encourage people to build up a nest egg. 401(k) plans are named after section 401(k) of the Internal Revenue Code.

When you open a 401(k) account, your employer can offer to match some or all of your contributions. Additionally your contributions are made pre-tax, which means you will not have to pay taxes on the money until you withdraw it in retirement.

How Much Can You Contribute to a 401(k)?

The maximum amount you are allowed to contribute to your 401(k) per year is determined by the government. You can always check the IRS website to see the current contribution limit. For 2021, the limit is $19,500 unless you’re 50 or older in which case you can contribute an additional $6,500. That $6,500 is considered a “catch-up” contribution.

When Can You Start Withdrawing Money from Your 401(k)?

You can start withdrawing from a retirement account without penalty at 59 ½ years old. However because the money was not taxed when you contributed it to your account, upon withdrawal it will be considered taxable income.

Do I Have to Withdraw from My 401(k)?

Many people are faced with an important decision when they reach retirement age: whether to withdraw from their 401(k) or not. Withdrawal can be a tricky process, but it is an important topic for anyone who has a 401(k).

If you are still actively employed with the company sponsoring your 401(k), you can defer minimum distributions for as long as you work. When you quit, retire or lose your job, you must start taking distributions from your account once you reach the age of 72, these are called Minimum Required Distributions (MRD).

The MRD is calculated “for each account by dividing the prior December 31 balance of that IRA or retirement plan account by a life expectancy factor that IRS publishes” IRS.com

How to Start a 401(k)?

A 401(k) is an employer sponsored retirement account, meaning you can’t start one on your own (unless you’re a business owner). With a 401(k) employees can start saving for their future right away. Employees can contribute pre-tax dollars to their 401(k), allowing them to save more than they would if they were saving post-tax dollars.

For example.Let’s say you earn $2,500 per paycheck before taxes and health insurance are taken out. 

If you don’t contribute anything to your 401(k) the entire amount is taxed and you’d see around $350 taken out for taxes. However, if you contribute just 5% of your paycheck ($125) you’d only have $325 taken out for taxes.

While you will have contributed $125 to your 401(k), the difference in your paycheck wouldn’t be $125. It would be closer to $100, because you aren’t taxed on the $125 you saved for retirement.

What You Should Know About Your Company’s 401(k) Plan

Unfortunately, many people are unaware of the 401(k) plan offered by their employer. They don’t know how it works, what benefits they receive from it, and other important information. In this section, we will give you a basic overview of a 401(k) plan and how it can benefit you.

This overview should be enough for you to have a good understanding of your company’s 401(k) plan.  It is an employer sponsored savings plan that pays for a portion of the employee’s retirement.

In order to find out if your company offers a 401(k) plan, you can ask your Human Resources representative or check with your company’s benefits coordinator.

Company Match and Vesting in Your 401(k)

Companies often match 401(k) contribution plans to a certain amount, usually by offering to match a percentage of an employee’s contribution. 

For example, if you contribute 10% to your 401(k), your company could offer to match 100% up to 5%. Let’s say your salary is $100,000 (easy math), then 10% would be $10,000. Your company would match dollar for dollar the first 5%, so they would contribute $5,000. That’s a lot of extra cash you got just from the matching program your company offers.

For this reason, it is usually recommended that you at least contribute enough to your 401(k) to take full advantage of the matching your company offers.

Vesting is a time-based system that companies use to allow employees to keep their benefits and money according to the length of service. Usually, there are no rewards granted until employees have reached a certain length of time. Meaning the money the company contributes as a match won’t actually be yours to take if you leave before meeting the vesting schedule. For example, 1 year of service; 5 years; 10 years; etc.

The vesting schedule can be based on time or it can be based on achieving goals like buying shares or hitting quarterly targets.

Different Types of Employer-Sponsored Retirement Plans and How they Work for Employees

There are two types of employer-sponsored retirement plans, the 401(k) and a pension plan.

The 401(k) is one type of employer-sponsored retirement plan. It is an individually owned retirement account that is funded with pre-tax dollars. The individual then has to pay taxes when they withdraw the money in the future. A matching contribution happens when the employee’s employer contributes a predetermined amount to their 401(k) account based on their salary, which increases their savings rate and helps them meet their retirement goals faster. Examples of matching contributions might be 50% up to 6%, or 100% up to 4%.

The second type of employer-sponsored retirement plan is a pension. Also known as a defined benefit plan because it provides employees with predetermined benefits upon retirement. With pensions, employers take care of investing for employees and provide them with regular income in their old age.

401(k) Basics for New Employees

A 401(k) is a type of retirement plan where you save money for your future, tax-deferred. A 401(k) is not an investment plan – but the most important part of one.

The money that goes into a 401(k) account can be invested in a variety of ways from stocks, and mutual funds, to bonds and CDs. The account is managed by professionals who will invest it and earn more money for you.

There are several differences between a 401(k) and a regular savings account. 

With a 401(k), if your company offers matching contributions, then they will match some of the contributions that you make to this plan up to a certain limit,this matching contribution is not available with a savings account or personal investment account.

Additionally retirement accounts like a 401(k) or IRA have withdrawal penalties if you take out the money before you’re 59 ½ years old. A regular savings account has no such penalties. 

Finally, at a certain point with a 401(k) you are required to take minimum distributions when you reach the age of 72. Again a personal savings account has no required wirthdrawals.

Investment options for your 401(k)

There are many investment options for your 401(k) through which you can invest money according to your risk appetite. You can choose from stock funds, bonds, mutual funds, CDs, individual stocks, and more.

Here are some points to keep in mind when looking for an investment option for your 401(k):

1) The investment should be appropriate for your age and risk tolerance.

2) The investment should have low fees so that more of the money goes towards growing the account balance instead of being eaten up by costs.

Beneficiaries of Your 401(k)

People can designate a beneficiary of their 401(k) at any time but most do so when being on-boarded at a company by completing a beneficiary designation form. If you don’t, it will default to a spouse who is designated as a beneficiary.

You must provide at least one primary beneficiary and one contingent beneficiary. Once any assets are transferred, the contingent beneficiary will no longer have access to them.

Related: Figuring Out Your First Full-Time Job Benefits

What are the Tax Benefits of Having a Company-Sponsored Retirement Plan? 

A company-sponsored retirement plan brings numerous tax benefits to employees, employers and the government. This type of plan is a great way for employees to save money for their retirement and lower the amount of income taxes they must pay. 

A company-sponsored retirement plan is a significant benefit for employers because it will help them retain their talented employees and ensure that they have a skilled workforce in the future. A company-sponsored retirement plan also provides tax benefits to the government because it will reduce the reliance on Social Security spending.

Some of the benefits that come with a company-sponsored retirement plan are:

– Lower income taxes

– Greater savings

– More comprehensive coverage

– Control over contributions and investments

But that doesn’t mean you can’t also benefit from Individual Retirement Plan. If your income level allows, by starting an Individual Retirement Account (known as IRAs), you can set aside additional funds for your retirement.

A Roth IRA is one type of retirement savings account that allows you to save or invest after-tax dollars into an account that will grow without being taxed. Roth IRAs are funded with after-tax money, so if you don’t have any traditional IRA contributions in your paycheck, you can still fund this type of IRA with earnings from self-employment income or other investments. That makes it an excellent option for people who are looking for tax benefits without losing any money upfront.

A traditional IRA is a type of individual retirement account these accounts work by having you contribute a portion of your salary each month to the account and then investing it into stocks, bonds, or other investments that will provide returns on your investment.

A SEP IRA is a retirement account for small businesses and self-employed people. It allows employers to set aside a portion of their salary into the IRA, and then receive tax breaks on that money.

A Solo 401(k) is a retirement account that allows a business owner (with no employees) to contribute up to $19,500 per year of pretax income. Unlike a SEP IRA, only the business owner can contribute, but they don’t have to be actively working in order to make a contribution.

What to do if Your Employer doesn’t Offer a Company-sponsored Retirement Plan?

If you are looking for a company-sponsored retirement plan, you might be met with disappointment. First of all, many employers do not offer a company-sponsored retirement plan due to legal and financial constraints. 

If your employer doesn’t offer a retirement plan, then the following options could help you out:

  • investing in a traditional IRA, 
  • getting a Roth IRA,

What happens to a 401(k) when you quit?

A 401(k) allows employees to contribute money directly from their paychecks to the account, which then grows tax-deferred over time. When an employee retires, they can withdraw money from their account for retirement.

Leaving it with the company is generally allowed if you have over $5,000 in your account. If you’ve been happy with your investment options and the running of your 401(k) it could be a good option.

If you (the employee) leaves the company before reaching retirement age, you may be able to take some (has it vested?) of your 401(k) savings with them in one of two ways: withdrawal or rolling over. 

Withdrawing is basically cashing out in a lump-sum distribution – while you can do this, it’s not usually recommended by financial advisors. Because when you cash out you’ll then be taxed on the entire amount – which could lead to a very large tax bill.

Rolling over your funds into an IRA is like making another deposit into your retirement account—you get to keep all the investment gains and the money you make off those investments will be tax-deferred. 

Another option would be to rollover your 401(k) plan from your previous employer to your new employer, assuming your new company offers a 401(k) plan.

To decide what would be best for your situation, you’ll likely want to consult a financial advisor to come up with a personalized financial plan.

Withdrawal Penalties

The money in your retirement account is meant for retirement, because of this you may face a withdrawal penalty if you start to withdraw or cash out of the account before you are 59 ½ years old. 

Withdrawal penalties on retirement accounts are different for each type of account, penalties on 401(k) withdrawals are 10%, but there are some exceptions to the rule, such as hardship distributions.

If you want to see how much you may pay in penalties, check out this 401(k) Early Withdrawal Calculator.

Does your 401(k) continue to grow if you quit?

If you are considering leaving your job, it is important to consider the tax implications of withdrawing money from your 401(k). You may be tempted to take out everything you have saved for retirement, but the government will tax the distribution at your marginal income tax rate, which could be as much as 37%.

If you have a 401(k) that is invested in stocks then it may grow over time. If you are not comfortable leaving that money with your company or do not trust them with your investment portfolio then rolling over assets into an IRA may be a good option. 

For example, if you have stocks like Apple and Google that are now worth more than when you bought them, rolling those stocks into an IRA would be a wise financial decision. This way, those gains will compound on themselves and will be tax-deferred as well as compounded annually.

What happens to Your 401(k) when you die?

The company will mail a form to your designated beneficiary that they are required to fill out. If the company doesn’t receive any response from the beneficiary then it will distribute your 401(k) according to the terms of your plan.

Do beneficiaries pay taxes on 401(k)

401(k) accounts can be used to generate income during retirement. And like any other type of retirement account, the beneficiary may have to pay taxes on 401(k).

The Internal Revenue Services (IRS) defines a beneficiary as an individual who receives benefits from the plan sponsored by your employer and is not required to perform services or take actions in order for this individual to receive these benefits. 

This means that if you inherit a 401(k) plan and all you do with it is let it sit in your bank account, you will be considered a beneficiary and will have to pay taxes on 401(k). 

401(a) vs 401(k)

A 401(a) is an alternative to 401(k) where employees get tax-deferred contributions but not all the features like company matching or profit sharing contributions.

What happens if you don’t roll over a 401(k) within 60 days

If you do not take the required steps to rollover your 401(k), it will be considered an unclaimed property and will be transferred to the state.

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