What is a 401k?

A 401k is a retirement plan that is offered to you by your employer. A 401k is the most common defined contribution retirement plan, which means that you make contributions to the plan with your money. How to Contribute Your...

A 401k is a retirement plan that is offered to you by your employer. A 401k is the most common defined contribution retirement plan, which means that you make contributions to the plan with your money.

How to Contribute

Your employer will typically work with an outside financial services organization that will manage the retirement accounts. Your company will serve as the plan sponsor but won’t have anything to do with actually investing your money. The financial services firm that administers the account may be a mutual fund company (like Fidelity or Vanguard), brokerage firm (like Charles Schwab or Merrill Lynch), or insurance company (like Prudential or MetLife).

Once you sign up for a 401k through your employer, you can choose how much you want to deduct from each paycheck to contribute to your 401k. You are required to determine how you want your funds invested. You have the option to choose your funds, or you can choose a pre-determined plan that a financial company has put together based on your age. The younger you are, the riskier the plan, since you have more time in the workforce to make up any losses. As you age, the plans become less risky.

When investing in retirement, it’s recommended to invest in mostly stocks since those have the best chance to generate positive returns. You’ve probably heard about the importance of diversifying your portfolio. By adding things like bonds, you’ve spread out your investment so if one piece takes a hit, you have the other items in your portfolio to help you recover faster and reduce the volatility of your retirement fund.

Federal Regulations

Any money you contribute to your 401k comes out of your paycheck before taxes. You do not pay any tax on it at the time that it is moved into your 401k account. Given this tax break, it makes sense to contribute the maximum amount each year. If you are under 50 years old, you are eligible to contribute a maximum of $18,000 per year. If you are 50 or older, you can make catch-up contributions up to an additional $6,000 for a total of $24,000 per year.

The contribution limits change annually due to inflation, so be sure to stay up to date on your contribution amount each year. Inflation causes the gradual reduction of the value of the dollar, so you will eventually need to contribute more dollars to meet or exceed the same purchasing power.

A helpful tip is to contribute at least the amount that your company matches. For example, your company may contribute up to three percent. If you contribute three percent, then your company will contribute three percent, and you will essentially get free money just for planning for your retirement. Check with your human resources department to identify your company match.

When to Withdraw

To avoid paying any penalty fees, you need to keep the money in your retirement account until you are 59½. If you withdraw any funds early, you will be charged a 10 percent early withdrawal fee on top of the regular income tax that you owe. Remember that you were not taxed when the funds were first moved to your retirement account.

Keep in mind that the IRS will waive the 10 percent penalty if you can prove financial hardship. Based on your plan’s rules, you may be able to take out money without incurring the penalties before 59½ if you use the funds to cover a sudden disability or for medical expenses that exceed 7.5 percent of your adjusted gross income if under the age of 65.

Some 401k plans will let you take out a loan to borrow against your account. You have to repay the loan within a set period. The parameters will be determined when you finalize the loan details. If you do not pay back the loan, it will be treated as an early withdrawal, and you will incur the penalty fees.

The drawbacks to taking out a loan include reducing the money you have for your retirement, you have to pay interest on the borrowed amount, and you must pay back any outstanding amount within a few months if you lose your job.

When you turn 70½, you must make the minimum withdrawals from your 401k. When you’ve saved for that long, you deserve to enjoy the fruits of your labor.

Leaving Your Job

If you leave your job, you have a few options of what to do with your 401k. First, you can roll it over into an IRA. Your money will continue to grow tax-free, but you have more flexibility with the investment choices since you are not limited to the choices of your old plan.

Second, you can roll it over into your new employer’s retirement plan. This is easily facilitated through some paperwork changes.

Third, you can leave your 401k as is with your previous employer. Check with your human resources department on any limitations to doing so.

Lastly, you can request a distribution but will be charged the penalty fees for early withdrawal if you are younger than 59½.