What Is a 401(k)?
You’ve probably heard about 401(k) plans as one of the most common retirement savings vehicles. 401(k)s are essentially retirement plans designed and managed by an employer. 401(k)s come with unique attributes – it is essential to understand their features in your retirement planning and how they can help you reach your retirement goals.
Like with many other common retirement savings vehicles, 401(k) plans allow you to defer taxes on both your contributions to the account as well as your dividends and capital gains. You won’t pay taxes until you begin withdrawing from your 401(k).
Furthermore, many employers often offer bonus employer contributions if you do contribute to a 401(k) plan. For example, an employer may have a plan where they contribute the same as what you contribute, up to the first 6% of your pre-tax salary. For example, if you make $80,000 a year and contribute 6%, or $4,800, your employer would also contribute $4,800 and bring your total retirement contribution that year to $9,600.
Drawbacks of a 401(K)
As one of the common retirement savings vehicles, 401(k)s also have some drawbacks. The first is that you may have significant restrictions in terms of what you can invest your 401(k) into, as the employer’s plan might limit your investment options to just a few mutual funds.
Additionally, many employers have a caveat where their contribution does not vest until you have worked for them for a certain period of time. If you leave your employer before you’ve worked the required number of years, you will only be able to take your contributions with you – the employer’s contributions will not be yours when you leave.
Lastly, 401(k) plans are designed to encourage withdrawal near retirement. If you withdrawal from your 401(k) before you reach 59.5 years old, or 55 years old if you leave your employer early, then you will be slapped with a 10% extra tax penalty on top of the taxes you owe on the contributions and gains.
It is also worth noting that, although uncommon, some companies offer a Roth 401(k). Like a Roth IRA, the money that is contributed has already been taxed and will not face taxes on the withdrawal. A Roth 401(k) also is significantly different from regular 401(k)s in that you can access your money without a tax penalty if you’ve had the account for at least five years.
You may be using many common retirement savings vehicles, ranging from 401(k)s to IRAs to annuities and more. For your retirement planning, it is important to understand your retirement goals, timeline, and the benefits and risks of each of the common retirement savings vehicles.
For retirement planning, a 401(k)’s main benefit usually comes from the employer’s matching contributions, as those can add up significantly over time. After you leave your employer though you may worry that the 401(k) is no longer a good fit for your retirement goals because it no longer receives matching contributions and may still be heavily restricted in terms of investment options.
The good news is that you can rollover your 401(k) into a 401(k) with another employer or into other common retirement savings vehicles such as a regular IRA or a Roth IRA.
Rolling over your 401(k)
The process of rolling over your 401(k) is relatively straightforward. If you are rolling it over to a new employer’s 401(k), you should contact that employer’s trustee for retirement planning. If you are rolling it over into an IRA, you should contact your broker.
While rolling the non-Roth 401(k) into an IRA will not result in a tax liability, if you roll over a regular 401(k) to a Roth IRA then it is considered a “Roth Conversion” and you will owe some taxes. Depending on the type of rollover there also might be various rule changes, such as regarding holding periods, to take account of.
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401(k)s are one of the major common retirement savings vehicles and can be an essential part of your retirement planning. If you have an employer that contributes significantly to your 401(k) and the 401(k) has relatively varied investment options, then the 401(k) can be a major driver to help you reach your retirement goals.
*All investing is subject to risk, including the possible loss of the money you invest. **The projections or other information generated by Zoe Financial, Inc. regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.