Workers keep the economy functioning for the ultimate benefit of everybody. This is why workers deserve to have their needs taken care of at retirement when they are no longer able to earn an income. One way for a worker to start preparing financially for retirement is through a 401(k) plan.
What is a 401(k) plan?
Sponsored by an employer, a 401(k) plan allows you as a worker to contribute a portion of your paycheck to a tax-advantaged retirement account where your money can accrue in value. These types of plans are named after a specific section of the Internal Revenue Code of U.S. law.
If you sign up for a 401(k) account as an employee, you are agreeing to have a portion of your paycheck contributed directly into a retirement account. In some instances, an employer may offer to match your contribution, either in part or whole. You will be able to select from various options for investing your money. These options will usually be mutual funds.
How do 401(k) accounts work?
When investing in a 401(k) account, your funds will be managed by a financial professional with knowledge of economics and the financial markets enabling more informed investment decisions. This empowers you to access a professional fund manager without having a large amount of capital. Also, you may have the option to self-direct your 401(k) investments.
Traditional 401(k) accounts
When enrolled in a traditional 401(k) plan, your contributions will come from pre-tax gross income, meaning this will be money prior to income taxes being deducted. Therefore, your income tax liabilities will decrease since your taxable income will not include the funds contributed directly to your 401(k) account. Note these funds will be taxed upon withdrawal – usually be during retirement.
Roth 401(k) accounts
Another type of employer-sponsored retirement plan is a Roth 401(k) account. These retirement accounts have you contribute income from your paycheck just like a traditional 401(k), except the contributions will be made after income taxes have been deducted. On the other hand, these funds will not be taxed when you withdraw.
Contribution limits
There are annual limits to how much you can contribute to your 401(k) account. These limits are inflation-adjusted meaning they change every year. For 2022, the contribution limit for workers younger than 50 years is $20,500 annually. Those who are 50 years of age or older are allowed to make an additional $6,500 contribution, referred to as a catch-up contribution.
There are also limits to matching contributions your employer is allowed to make that may affect those at higher income levels. Your financial advisor will be able to help you understand these rules and regulations to ensure you can maximize your retirement investment strategy.
Required minimum distributions
Workers who have retired and have reached the age of 72 years will be required to withdraw funds from their 401(k) accounts at specified percentages.
Early withdrawals
If you decide to withdraw funds from your 401(k) account before you reach age 59 ½ years, you will be charged a penalty by the Internal Revenue Service (IRS). However, in some instances you may be allowed a hardship withdrawal exception allowing you to withdraw early without penalties if you are experiencing certain types of hardships. This can include funeral costs, buying a home or medical expenses.
Your financial advisor can help you with deciding if you should be withdrawing early as well as various other aspects of your retirement planning.