Of all the available retirement savings accounts, 401(k) plans are by far the most common and popular, so it's important to understand and weigh all your options before choosing a retirement savings plan. If you are considering a 401(k), or want to learn more about your existing plan, this quick guide can help!
What is a 401(k)?
A 401(k) is a defined-contribution retirement account that offers tax advantages to its owner before and after retirement. For a traditional 401(k), investment earnings are tax-free until you withdraw them after retirement. However, with other types of 401(k) plans, withdrawals can be tax-free.
Many employers offer 401(k) options to their employees and will, traditionally, match their employees' contributions up to a certain percentage after a certain amount of time. If you have a 401(k) account through your employer, you can make contributions through automatic payroll withholding, which means that the money you’re contributing into your 401(k) comes directly out of your paycheck and cannot be accessed. So, don’t contribute more than you can afford.
Types of 401(k) Plans
There are two main types of 401(k) plans: traditional and Roth.
While similar in many ways, traditional and Roth 401(k)s are taxed differently. Employees can enroll in one or both types of plan, depending on what their employers offer.
How are traditional and roth 401(k)s taxed?
- Traditional: Contributions are tax-free until you withdraw the money, typically after retirement.
- Roth: Contributions are taxed, but the money you withdraw is tax-free.
Other types of 401(k) plans exist, including:
- Simple: Designed for small businesses with no more than 100 employees. Employers must either match the employee's contribution or make a non-elective contribution of 2% of each employee's salary.
- Solo: Designed for self-employed individuals with no employees.
- Safe Harbor: Popular among small businesses. Employers are required to match contributions, and those contributions are immediately invested.
What are the Benefits of a 401(k)?
401(k) plans offer lots of benefits to help maximize your savings.
Tax Savings
With a traditional 401(k), you can grow your retirement savings tax-free. Your contributions immediately reduce your tax burden, and you won't have to pay taxes on the money in your account until you withdraw it.
With a Roth 401(k), you trade immediate tax benefits for a tax-free withdrawal at retirement.
Employer Match
Employers with matching programs will contribute a designated percentage or certain dollar amount for each dollar you contribute to your account.
Fiduciary Standard (AKA, protection for your best financial interests)
All 401(k) plans are covered by the Employee Retirement Income Security (ERISA) Act, which means that plan administrators have a fiduciary duty to act in your best interest. Plan costs must be reasonable, and investment options should be stable. Important information, such as fees, must also be disclosed prior to plan adoption.
How Much Should You Put into a 401(k) Each Month?
There are no hard and fast rules when it comes to 401(k) contributions, but keep in mind that your monthly contribution will be withheld from your paychecks, so don’t contribute more than you can afford. Unlike a normal savings account, the money you contribute to your 401(k) cannot be accessed easily once you put it in.
The contribution limit for 2020 is $19,500, which equates to $1,625 per month. Workers who are 50 and older may contribute an additional $6,500 for the year.
To maximize your retirement savings, find out how much you need to save to qualify for an employer match. Maximize your employer contribution – it's essentially free money and, if you can, you should take advantage of it.
A good rule of thumb for how much you should be saving is to save around 10% or more of your annual income and do your best to increase your savings rate over time.
It's never too early or too late to start saving for retirement. If you need help, contact us and speak to a local expert today!
