What is a 401(k)?
A Beginner’s Guide
401k is synonymous with retirement, but how many of us actually know what it is and all the rules around 401k accounts? We'll walk you through all the finer details, but we know you're busy, so we've also whipped up this handy table of contents for you, too. So, feel free to self-serve some of the most frequently asked questions about 401k plans or binge it all, top to bottom.
Now, onto the good stuff:
What is a 401(k)?
How does a 401(k) work?
What are the benefits of a 401(k)?
What happens to my 401(k) if I change jobs?
What is an IRA?
How is an IRA different from a 401(k)?
When can you withdraw from your 401(k) without a penalty?
How much should I be putting into my 401(k)?
What are the penalties if I cash out my 401(k) early?
What is a 401(k)?
A 401k is an employer-sponsored retirement account. It allows an employee to dedicate a percentage of their pre-tax salary to a retirement account. These funds are invested in a range of vehicles like stocks, bonds, mutual funds, and cash. Oh, and if you're curious where the name 401k comes from? It comes directly from the section of the tax code that established this type of plan — specifically subsection 401k.
How does a 401(k) work?
A 401(k) plan is a benefit commonly offered by employers to ensure employees have dedicated retirement funds. A set percentage the employee chooses is automatically taken out of each paycheck and invested in a 401k account. They are made up of investments (usually stocks, bonds, mutual funds) that the employee can pick themselves.
The money invested is tax-free and CW matches $0.50 for each dollar you contribute up to 5% of your salary. So, for example, if you contribute 5% of each paycheck, CW will give you an extra 2.5%. Don’t leave this free money on the table!
Financial experts recommend contributing the maximum amount each year, or as close to it as you can manage.
What are the benefits of a 401(k)?
401 tax benefits are hard to dispute, as they can offer workers a lot of financial security, including:
Employer match
Tax breaks
Shelter from creditors
In fact, let's dig into 401k benefits a little deeper.
401k employer match
Do you like free money? Good, now that we've got that out of the way, our company-matched 401(k) is basically that. CW offers 50 cents to the dollar, up to 50% of your salary. So, for example, say you make $40,000 a year and contribute 5% (which is $2,000), CW will match 50% of that. So, $1,000 free dollars.
401(k) tax breaks
The tax benefits of 401(k)s are like the triple-crown of finances. First, contributions are pre-tax. You don’t pay taxes on the money until you withdraw it when you retire. (At the earliest, this is age 59.5.)
Second, your 401(k) contributions are not counted as income, which could put you in a lower tax bracket. The result: your tax bill will be smaller for your having squirreled away money for your later years.
Third, your savings grow tax-deferred. In a regular investment account, your net gains and dividends would be taxed. But in a 401(k) plan, your money grows tax-free as long as it stays in the plan. This allows your earnings to compound -- which is just a fancy way of sayings, your earnings will earn earnings. (#baller)
401(k) shelter from creditors
If your finances take a turn for the worst, you won't have to worry about creditors coming for your 401(k). Your qualified retirement plan is protected by the Employee Retirement Income Security Act of 1974 (ERISA) from claims by judgment creditors.
What happens to my 401k if I change jobs?
You have a couple of options, but the one most would recommend is a 401(k) rollover. A 401(k) rollover is when you transfer your funds from your employer to an individual retirement account (IRA) or to a 401(k) plan with your new employer. A much less popular option is to cash out your 401(k), but this comes with massive penalties; income tax, and an additional 10% withholding fee.
What is an IRA?
While there are a number of benefits to 401(k)s, they're not the only retirement plan in the game. An IRA is an individual retirement account. Where a 401(k) can only be offered through an employer, an IRA account can be opened up by an individual whether they're associated with an employer or not. That means they're the best option for independent contractors without an employer or anyone who wants to do some extra retirement planning on top of their 401(k).
What is a Roth IRA?
A Roth IRA is a type of individual retirement account similar to traditional IRAs in many ways, but with some significant differences. One of the main differences is how the tax breaks are different: with a traditional IRA, the money you put in isn't taxed; with a Roth IRA the money you take out (once you've reached retirement) isn't taxed. Roth IRAs also have no requirements on when the money must be taken, so they can be a good tool to pass along wealth to your beneficiaries if you find you don't need the money in retirement.
What are the rules for a Roth IRA?
Roth IRAs are only available to people making less than $129,000 a year as an individual, or $191,000 for married couples. They have contribution limits of $5,500 a year, or $6,500 for those over 50. Unlike 401(k)s and traditional IRAs though, there's no penalty for withdrawing part of your contribution early.
What are the traditional IRA contribution limits?
A traditional IRA has the same contribution limits as a Roth IRA: $5,500 for most people, $6,500 for anyone over 50.
How is an IRA different from a 401(k)?
401(k) accounts are associated with your employment, as contributions are taken out of your wages before taxes. A traditional IRA is similar to a 401(k) in that contributions aren't taxed (they are deductible), but the key difference is that they are independent of your employer. A Roth IRA is also independent, but contributions are made after taxes. Withdrawals from your Roth IRA are tax-free, which makes them a smart choice if you think taxes will be higher in the future.
When can you withdraw from your 401(k) without a penalty?
Wondering when can you withdraw from 401(k)? 59 and 1/2 is the current age when you can take money out of your 401(k) without incurring a penalty. However, the money you take out is still taxed as income. At the age of 70, you will be forced by the IRS to start taking distributions from your retirement accounts.
How much should I be putting into my 401(k)?
Aim to save between 10% and 15% of your income toward retirement. Another piece of general advice is to put all of those funds into your 401(k) up until your employer's matching contribution amount. Once that has been reached, maxed out your Roth IRA contribution. If there are funds leftover (lucky you!) then consider putting those funds into your 401(k).
Another way to determine how much you will need to save is to look at what income amount you will need in retirement. Fortunately, there are a lot of calculators out there that will help you figure out your magic number. Here are two of our favorites.
Nerdwallet provides a great basic calculator that lets you play with different contributions and matching amounts.
CalcXL makes a recommendation on how much you should be saving based on projected inflation. Tip: You should aim for a retirement income of roughly 80% of your current salary.
What are the penalties if I cash out my 401k early?
If you withdraw funds from your 401(k) before the age of 55 and 1/2, then you will pay a 10% early withdrawal penalty and taxes on all the funds. This adds up. Assume you have $250,000 in your 401(k) and you want to take it out early. After penalties, you will have around $180,000. A loss of $70,000.