A Basic Guide to Understanding the 401(k)

National 401(k) Day is coming up on September 8, and it’s the perfect time to celebrate something truly special. It’s not just about a financial tool, but a pathway that can help you live a more cozy and secure retirement. The 401(k) plan has become a pillar of retirement savings here in the U.S. But it’s not just a plan – it’s your chance to build a strong foundation for your future.

But what exactly is a 401(k)? How does it work? Why should you consider one? Whether you’re just starting your career, well into your working years, or approaching retirement, this guide will supply you with the knowledge you need to make informed decisions about your financial future.

***A huge THANK YOU to Brian Hodel at Parkside Financial Bank & Trust for contributing his expertise to this article!***

What is a 401(k) Retirement Plan?

401(k) has become a common phrase thrown around the workforce and in retirement conversations. But we know it might still be unclear what exactly a 401(k) is. So let’s look at the definition, the purpose, and the types of 401(k) plans available.

Definition of a 401(k)

A 401(k) plan is like a personal savings account for retirement, provided by many U.S. employers. Employees can set aside part of their income and then invest it in various financial instruments like stocks, bonds, and mutual funds. But the thing that really makes 401(k)’s shine? The tax benefits! You can either reduce your taxable income today or enjoy tax-free income in retirement. Sometimes, employers may also contribute to employees’ 401(k) accounts, often through matching contributions. This boosts your savings even more!

Purpose of a 401(k)

The purpose of a 401(k) plan is to help you save money for your future, especially when you stop working. It’s like a treasure chest where you put a part of your paycheck every time you’re paid. This money is like a gift to your future self! So, when you’re older and want to stop working, you have a ‘nest egg’ saved up to enjoy life.

Types of 401(k) Plans: Traditional vs. Roth

Traditional 401(k): Every dollar you put in this account reduces your current taxable income by the same amount. This makes it easier to save today because the net cost, for you, is lower than if you put money into a regular savings account. When you use the money in retirement, you’ll pay taxes on the withdrawals at that time. This strategy works well if you expect your tax rate to be lower in retirement than it is today.

ROTH 401(k): Dollars put into a ROTH do not give you a tax deduction today. So, saving into a ROTH 401(k) does not reduce your taxes owed this year like a Traditional 401(k). However, because you have paid the taxes today, you do not owe taxes on the withdrawals in retirement (as long as you’ve had the account longer than 5 years and are older than 59 ½). This strategy works well if you think your tax rate will be higher in the future than it is today.

Good to know: Almost all plans will allow you to contribute to both types of accounts. Since we can’t predict future tax rates, it often makes sense to contribute to both if you can! However, this does not mean you will have two separate accounts. All of your savings will go into a single account, with the Plan ‘recordkeeper’ tracking the amounts you have in each bucket. You can also change which method you’re contributing to as you go along. So, you can evaluate what makes the most sense for you each year.

How does a 401(k) plan work?

Now that we have a better sense of what a 401(k) is, let’s chat about how they work. From eligibility and enrollment to withdrawing your money, this section covers what you need to know!

Eligibility and enrollment

Every employer may have different rules regarding when you’re eligible to participate and when you can enroll in your plan. Typically, you’ll have to wait at least three months from starting employment but no longer than a year to become eligible. After you’re eligible, look for your enrollment date – it might be monthly, quarterly, or semi-annually. Once you’ve cleared these steps, you can jump into the plan whenever you’re ready! 

Contribution options and limits

Employees make all contributions to a 401(k) through automatic payroll deductions. You’ll determine a percentage you’d like witheld each pay period and that money will be sent directly to your plan account. As of 2023, annual limits for contributions are: $22,500 for folks under the age of 50 and $30,000 for those over 50. Of course, the majority of savers are not able to contribute at these levels. But, if you are debating joining a 401(k) plan, we encourage contributing at least enough to get the full company match. If your company doesn’t offer a match, or you cannot afford to contribute the amount to get the full match, we recommend starting with 1% of your compensation and increasing it by 1% every year.

Investment choices within the plan

Your employer will determine what investment options you’ll have available to you once you begin saving your hard-earned income. Typically, they have hired outside experts to evaluate and monitor those options. Try not to let the task of picking investments intimidate you! The amount and consistency of your savings is far more important than picking the “right” investment. And most plans will have an investment choice that “Does It for You” such as a target date, balanced fund, or managed account. You can also ask your employer where to go for advice selecting the right investment for you. It’s common for 401(k) plan administrators to offer resources, tools, and educational materials to help you make informed decisions.

Vesting rules

Vesting refers to ownership, or what percentage of the account balance is yours. 100% of the contributions you make to a plan are always yours! But sometimes employers will apply a vesting schedule to funds they contribute. This means you may have to work for the company for a set period of time in order to keep 100% of the contributions from your employer should you decide to leave. This schedule should be included in your plan documents, but be sure to ask questions if anything is unclear!

Withdrawal of funds

Because the IRS intends for these assets to be there for you in retirement, typically you won’t withdraw funds until age 59 ½, or later. However, there are certain exceptions (like medical hardship) that allow earlier access to your funds. It’s important to understand that these withdrawals will often be subject to a 10% “early withdrawal” tax in addition to any ordinary income taxes you may owe. Furthermore, some plans, but not all, allow you to take a loan from your account balance. While there is no automatic penalty, you must pay back the loan balance in full, along with interest, to avoid any potential penalties.

Remember: Since these funds are earmarked for your retirement, it’s best to avoid tapping into them before 59 ½ unless you have no other options.

Why you should consider a 401(k)

Alright, we know what a 401(k) is and how it works. But why is it so important? Why should you take advantage of this particular financial tool? Let’s explore the advantages!

Importance of saving for retirement

Most everyone agrees that saving money is important. Whether for an unexpected expense, kids’ tuition, that much-needed vacation, or retirement. Unfortunately, people often put retirement savings on the back burner when juggling all these priorities because retirement seems so far away. However, there are no loans available for your retirement. And you may not have the ability to earn more income if your physical or mental health doesn’t allow you to work. That’s why retirement saving is so critical! Starting with something, no matter how small, can make a huge difference.

Advantages of contributing to a 401(k)

Okay, so we know that saving for retirement is important. But most people would also agree this can be difficult. A 401(k) is great because it offers many advantages over trying to save on your own. Those advantages include:

Consistent and Disciplined Savings

Because your contributions are made through payroll deductions, it’s much simpler to remain consistent! It’s like setting up a reliable automatic deposit for your future. By regularly funneling part of your paycheck to your 401(k), you cultivate a habit of saving that strengthens your financial foundation over time.

Employer match

As mentioned above, employers often offer to contribute to your 401(k) plan as well. What better way to make saving for retirement easier than by having your employer cover a portion of your savings goals? Also, this ‘match’ is considered part of your total compensation package, so not taking advantage of it is leaving hard-earned money on the table! When possible, always make the most of any company matching contributions.

Tax benefits

Whether you choose ROTH or Traditional, there is no right or wrong answer. You’re getting an excellent tax benefit either way! This allows you to accumulate more money for your retirement than saving in a traditional, taxable account. Additionally, if you are married and your combined earnings are less than $73,000, you may qualify for the “Saver’s Tax Credit” which helps offset the cost of retirement savings. If you are single, the amount of income to qualify is $36,500 or less. Credits are valuable because they reduce your tax liability (the amount you owe) dollar for dollar. You can claim this when you file your tax returns using IRA form 8880: “Credit for Qualified Retirement Savings Contributions.”

Compound growth

When you put money in your 401(k), it doesn’t just sit there. It grows because you’ve invested it! And the money that has grown also starts growing more money. It’s like a snowball getting bigger as it rolls down a hill. In real terms, using a 7% rate of return (a safe, historical average), every dollar saved in your 20s will grow to $16 in your 60s. If you are getting a dollar-for-dollar match from your employer, saving $1 today could equal $32 for you to spend in retirement!

This is important: If you feel behind on saving for retirement, don’t fret. It’s never too late to start! And the sooner you start with something, the better off you’ll be.

Remember, a 401(k) plan is not just a retirement account. It’s a powerful means to take charge of your financial future. It’s a promise to your future self that you’ll have the resources to live comfortably when you decide to leave the workforce.

As you consider your own financial path, keep in mind these key points:

  • Start early: The sooner you begin saving in your 401(k), the more time your money has to grow through the magic of compounding interest.
  • Contribute regularly: Consistent contributions, even small ones, can make a big difference over time.
  • Take advantage of employer benefits: If your employer offers a match, take full advantage of it. It’s extra money to boost your retirement savings.
  • Balance short-term needs with long-term goals: Saving for retirement doesn’t mean sacrificing all your current needs and desires. Find the right balance that works for you. If you are currently not saving anything for retirement, start with 1%. For someone making $50,000 per year, this breaks down to less than $10 per week.
  • Explore tax benefits: Understand how your contributions can provide tax advantages, especially if you’re eligible for the Saver’s Credit.
  • Keep Learning: The world of finance and retirement planning is always evolving. Stay informed about your 401(k) and other financial options to make the best decisions for your future. Reach out to your HR team for more information regarding your specific 401(k) plan and additional financial wellness resources.

While Prosperity Connection does not offer retirement planning services, there are still plenty of ways we can help! Our financial coaching services can help you build a budget that supports your retirement savings goal. We can also help you find the balance between those short-term needs and long-term goals mentioned above. Our coaches can even help you sift through recent financial statements to help you determine what questions to ask your HR team or 401(k) provider. Finally, we are always a great connection to valuable retirement planning resources! If you’re interested in learning how we might be able to help you, sign up for your first coaching session here.