A 401(k) is a tax-advantaged, employer-sponsored retirement savings account. These accounts allow employees to get a tax break as they contribute funds. They feature a host of other benefits as well as some drawbacks. In this guide, we’ll explain the ins and outs of 401(k) benefits and address everything you need to know about what is a 401(k).
What is a 401k and how does it work?
The money you deposit into your 401(k) is automatically withdrawn from your paycheck pre-tax. In other words, you won’t have to pay income taxes on the funds you deposit into your 401(k). This allows you to contribute more money while minimizing how much is cut from your monthly budget.
The money you contribute to your 401(k) is invested into a selection of investment options. Oftentimes, this will include a combination of stock or bond ETFs. You can choose your investments, but your options are limited to what your employer has already preselected.
Some employers offer additional 401(k) benefits in the form of a match, which is essentially free money. Yes, you read that right! Free money.
Some companies will match a certain percentage of your contribution up to a set limit. This means that as long as you’re depositing funds, you’ll be doubling your investment until you reach your employer’s contribution limit.
There’s a lot more to the benefits of a 401(k) and the drawbacks. If you still don’t have all the answers to the question, “What is a 401(k)?” don’t worry! We’ve compiled the top answers below.
How much should I contribute to my 401k?
You should contribute as much money to your 401(k) as your budget allows. If your employer offers a 401(k) match program, you’ll definitely want to max out your employer contribution if you can because it’s essentially free money.
Because of the tax benefits of a 401(k), the IRS regulates how much you can contribute each year. As of 2021, the annual limit is $19,500. However, if you’re 50 years old or older, you’ll be able to contribute an additional $6,500 annually.
What is the difference between a 401k and IRA?
The main differentiating feature of a 401(k) plan is that it’s only available through an employer. An individual retirement account, or IRA, is set up by an individual, and it doesn’t require sponsorship through an employer. Both a 401(k) and an IRA account offer tax benefits, but they do so in very different ways.
There are two types of IRAs—a traditional IRA and a Roth IRA. Contributions to 401(k)s and traditional IRAs are tax-deductible, but withdrawals are taxed as regular income, even during retirement. In contrast, Roth IRA contributions are taxed upfront in exchange for virtually tax-free withdrawals during retirement.
Can you withdraw from 401(k) while still working?
A 401(k) is meant to be a retirement account, so you may face penalties and fines if you try to withdraw your funds before you reach 59 ½ years of age.
There are some exceptions to this rule. For instance, if you are a first-time homebuyer, you might be able to make an early withdrawal. Once you reach the age of 72, you legally have to start making minimum withdrawals from your 401(k).
What happens to your 401(k) when you leave a job?
Even if you switch employers or leave your job for a different reason, your 401(k) benefits are still intact You might be able to keep your 401(k) with your former employer, bring it over into a new account with your new employer, or transfer it into an IRA. The options will depend on your specific situation.
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What is a good rate of return on 401k?
The rate of return on your 401(k) largely depends on how the market performs year after year. However, if you can afford an annual average of at least 5% or more—taking into account market highs and lows—you’re in solid territory.
4 Types of 401(k) Accounts
There are several different types of 401(k) retirement accounts. Take a look at some of the most common!
Traditional 401k: A simple employer-sponsored retirement savings account featuring pre-selected investment options. Contributions are made pre-tax, but withdrawals are taxed as regular income in retirement. Some employers may offer to match contributions up to a set limit.
Roth 401(k): A type of employer-sponsored retirement savings account that’s similar to a Roth IRA. Contributions are made after taxes, but withdrawals are essentially tax-free in retirement.
Solo 401(k) or Self Employed 401(k): A retirement savings account designed for sole proprietors and other self-employed people. It works essentially in the same way as a traditional 401(k) but it features higher contribution limits, which can be as large as $64,500 annually.
Safe Harbor 401(k): An employer-sponsored retirement savings account that’s very similar to a traditional 401(k) with the exception of one main difference. This type of retirement account ensures that the employer makes identical contributions to the retirement accounts of employees who make the same annual salary.
Best features of a 401(k) account
A 401(k) plan can help you boost your retirement savings with tax advantages and other perks. Here are the 401(k) benefits that stand out the most.
Any and all 401(k) contributions are automatically deducted from your paycheck pre-tax. Since you won’t be paying income taxes on the money you deposit, you can get more growth out of your funds without having to cut into your monthly budget. On top of this, 401(k) contributions are tax-deductible, so you might end up lowering your total tax bill at the end of the year.
Some employers will offer to match your 401(k) contributions. If your company maintains this policy, try to take full advantage of this free money.
Although a 401(k) is a retirement account and you’ll face penalties if you withdraw funds before 59 ½ years of age, there are some exceptions to this rule. First-time homebuyers may be able to withdraw from their 401(k) for a mortgage down payment. In some instances, you may also be able to take out a 401(k) personal loan.
Advantages & Disadvantages of a 401(k)
All 401(k) retirement accounts come with a unique set of advantages and disadvantages. Here are some of the pros and cons of a 401(k)!
Advantages of a 401(k)
- Pre-tax contributions allow investments to grow tax-deferred.
- Contributions are tax-deductible.
- Some employers will match your contributions.
- There is some leniency surrounding early withdrawals.
- It’s possible to take out 401(k) loans for extra financing.
- Rolling over funds into a new employer account or IRA is fairly easy to do.
Disadvantages of a 401(k)
- Even though contributions are made pre-tax, withdrawals are taxed as income.
- You have limited choice in terms of investments.
- There are penalties if you withdraw funds before you reach 59 ½ years of age.
- Your annual contribution limits are capped at $19,500.
401(k) vs IRA
Simply put, a 401(k) is employer-sponsored, features an annual contribution of $19,500, and all contributions are made pre-tax.
Both traditional and Roth IRAs have lower contribution limits than 401(k)s. They come in at $6,000 annually, or $7,000 annually if you’re 50 or older.
Traditional IRA and 401(k) contributions are made pre-tax. However, withdrawals are taxed as regular income in retirement.
On the other hand, contributions to a Roth IRA are taxed immediately, but withdrawals in retirement are virtually tax-free. Many people end up paying fewer taxes on their retirement investment when they put money into a Roth IRA as opposed to a 401(k).
Investment Strategy: How Your 401(k) Fits Into The Larger Picture
When it comes to saving up for retirement, a 401(k) is a powerful tool. However, they only account for one aspect of your finances.
In most cases, you won’t be able to touch your funds until you reach retirement age. This means 401(k) plans aren’t very helpful for short-term goals, so you may want to explore other investment accounts that offer greater accessibility.
Take MoneyLion’s investment accounts as a prime example! These accounts feature fully-managed investment portfolios that you can customize based on your savings goals and risk tolerance.
You can deposit as much or as little as you want. The account allows you to access your funds at any time, too. With a monthly set rate of $1, the MoneyLion investment accounts will never charge you any management fees. Diversify your savings and take charge of your financial future today by learning more about MoneyLion’s investment accounts.