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What Is a 401(k)? Everything You Need to Know

If you just started a new job and you’re looking at the 401(k) options that are available, you probably have questions about how it all works.

You might be wondering: How do I know these are good investment options? How much should I invest? What kind of return should I expect? And what in the world does “vesting” mean?

If you’re leaning on your 401(k) to be a big part of your financial picture, it’s important to get your questions answered. Your golden years literally depend on investment choices you make today. Learning how your 401(k) works is the first step toward making confident decisions about your retirement future.

Let’s get started!

What Is a 401(k) Plan?

Let’s start with the basics. A 401(k) is an employer-sponsored plan for retirement savings. It allows employees the benefit of having retirement savings taken out of their paychecks before taxes. If your workplace offers a 401(k), you’ll fill out an enrollment packet that includes information about vesting, beneficiaries and investing options.

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Why is it called a 401(k)? The 401(k) plan is named for the 401(k) subsection of the tax code that governs how it works. That’s really all there is to it. The same goes for other plan types like the 403(b). Easy enough, right?

How Many Types of 401(k)s Are There?

There are two basic types of 401(k)s—traditional and Roth. Both are employer-sponsored retirement savings plans, but they’re taxed in different ways.

A traditional 401(k) offers tax benefits on the front end. Your money goes in tax-free, but you pay taxes on the employer match (if you have one) and the withdrawals you take out in retirement—that includes all the growth on your contributions as well.

A Roth 401(k) offers tax-free growth. What does that mean? Your contributions are taxed up front with after-tax dollars, but then you don’t pay taxes on your contributions or their growth when you retire. You will still owe taxes on employer contributions.

There are also a few other types of 401(k)s available for folks who are self-employed or own small businesses:

  • Solo 401(k): Also known as a one-participant 401(k), the solo 401(k) was created for business owners who work for themselves and don’t have any employees. It allows you to make contributions as both an employee and as an employer.
  • SIMPLE 401(k): If you’re a small business owner with no more than 100 employees, then the SIMPLE 401(k) is for you (it’s very similar to a SIMPLE IRA). As an employer with this plan, you must offer a matching contribution of up to 3% of each employee’s pay or put in 2% of each employee’s pay (even if they don’t make contributions).1 

How Much Should You Invest in Your 401(k)?

If your employer offers a match, you should at least invest enough to take full advantage of that perk. Don’t say no to free money!

The good news is the vast majority of companies (86%) with a 401(k) plan provide a match on employee contributions.2 And the average employer match is around 4.5% of your salary.3 Even if your employer match is less than that, that extra money can make a big difference in your nest egg over time.

After you take advantage of the match, then what? Overall, we recommend that you save 15% of your income toward retirement. But does all of that need to be in your 401(k)? Not necessarily. Here are a couple options:

  • Option #1: You have a Roth 401(k) with great mutual fund choices. Good news! You can invest your whole 15% in your Roth 401(k) if you like your plan’s investment options.
  • Option #2: You have a traditional 401(k). Invest up to the match, then contribute what’s left of your 15% to a Roth IRA. Your financial advisor can help you get one started! If you contribute the maximum to your Roth IRA and still have money left over, you can go back to your traditional 401(k).

The most important factor in having a secure retirement is contributing consistently into your 401(k) over the long haul. 

What Is the Current Contribution Limit for Your 401(k)?

The current yearly contribution limit for a 401(k) in 2021 is $19,500, according to the IRS. If you are 50 or older, you can make catch-up contributions, increasing your annual limit to $26,000.4

What Should Your 401(k) Be Invested In?

We recommend diversifying your portfolio by including an equal percentage of funds from four different families of mutual funds: growth, growth and income, aggressive growth, and international. Even if you don’t have great funds to choose from, it’s worth it to at least contribute enough to get the company match.

Work with your financial advisor to choose mutual funds with a long history of above-average performance. With your workplace 401(k) you may not have as many fund options as you do with an IRA, but your investing pro can help you make the most of the choices you do have.

As your investments grow, you should regularly rebalance your portfolio with your financial advisor to minimize risk.

When Should You Invest in Your 401(k)?

This is important, so listen up! Don’t start investing until you’re out of debt (everything except your mortgage) and have a fully funded emergency fund. If you’re currently investing but still have any debt besides your mortgage, it’s time to hit the pause button! Temporarily stop putting money into your 401(k) and focus on taking care of those two steps first.

Why? Because your income is your greatest wealth-building tool. And when your income is tied up in debt payments, you’re robbing yourself of a chance to build wealth. Debt equals risk—get it out of your life as fast as you can using the debt snowball!   

And if you start investing without an emergency fund in place, where do you think you’ll look for money when the air conditioner in your home dies in the middle of July? That’s right, your 401(k). And if you take money out of your 401(k), you’re not just putting your retirement future at risk. You’re also going to get hit with taxes and early withdrawal penalties that will eat up most of your nest egg before you even see it. That’s why having an emergency fund with 3–6 months’ worth of expenses is so important!

Being debt-free with a fully funded emergency fund gives you a firm foundation that will protect your investments when life happens. And believe us, life will happen!

How Do Fees Impact Your Investing?

Fees can be confusing and overwhelming, but it’s important that you understand the full picture of how fees affect your investing portfolio.

Your 401(k) can seem like an expensive way to invest, but if you’re getting a company match on your contributions, the gain is just about always worth it. Your financial advisor can help you understand the difference between different types of funds so you can choose the best option for you.

Keep in mind that if you’re choosing funds based solely on fees, you’re missing an important part of the picture. While some funds may seem appealing because they offer low fees, it’s worth a second look to make sure you’re not sacrificing performance. You’re looking for a combination of low fees and strong returns.

A good financial advisor will be able to clearly explain how fees affect your investments. If your pro tries to dodge the question, that’s a bad sign.

What Does It Mean to Be Vested?

Vested is a term used to talk about how much of your 401(k) belongs to you if you leave your job. The money you contribute is yours, but some employers have guidelines about how much of their matching contribution you can take with you.

For example: If your company increases the amount you are vested in by 25% every year, leaving your job after only two years would mean you could only take 50% of the employer contributions to your 401(k) with you. Once you’re fully vested, you keep 100% of the employer contribution. Your HR department can provide specific information about your company’s vesting guidelines.

What Happens to Your 401(k) When You Leave Your Job?

You basically have four options when you leave your job: Do nothing and leave the money in your old 401(k), roll it over into an IRA, roll it into your new employer’s 401(k) plan, or cash out your 401(k).

Let’s get this out of the way: Do not cash out your 401(k) plan. Bad idea! Here’s why: When you cash out your 401(k), you don’t even get to keep all of the money! You’ll owe taxes on the total amount as well as a 10% withdrawal penalty.

Let’s say you’re in the 24% tax bracket and decide to cash out the $10,000 you have in your 401(k) plan when you leave your job. Even though you started with $10,000 in your 401(k), you’ll be left with only $6,600 after taxes and penalties.

Your best option is to roll over your 401(k) funds into an IRA because it gives you the most control over your investments and what mutual funds to choose from.

If you rolled that $10,000 over to an IRA and let it grow for 30 years, it could be worth about $267,000! Even a small cash-out has a big impact on your savings. Your financial advisor can help you roll over any old 401(k)s so you get the most out of your investment.

What Are the Rules for 401(k) Withdrawals and 401(k) Loans?

When life happens, it’s easy to turn to the savings stashed in your 401(k). The money is just sitting there, right? Turns out, withdrawing money from your 401(k) early is more complicated than that.

According to the IRS, you can’t withdraw money out of your 401(k) before you reach the age of 59 1/2 without paying income taxes and a 10% early withdrawal penalty.5

But there is a “loophole”: 401(k) loans allow you to use your retirement savings without paying penalties or taxes as long as you pay the money back. Of course, doing this comes with a bunch of rules and things can go wrong really fast.

Here’s why 401(k) loans are a really bad idea:

  • You have to pay back the amount you withdraw with interest.
  • Your investments into your workplace 401(k) account are pre-tax, but you’ll pay back the loan with after-tax dollars. That means it will take longer to build up the same amount.
  • You’ll have to pay additional taxes and penalties if you don’t pay back the loan in a certain time frame.
  • If you leave your job for whatever reason and still have an outstanding 401(k) loan balance, you have to pay it back in full by the tax filing deadline of the following year, including extensions (thanks to the Tax Jobs and Cuts Act of 2017).6 Under previous law, you had 60 to 90 days to pay off your balance completely.

That’s a lot of good reasons to keep your hands off your 401(k) until you reach retirement age.

Should You Work With a Financial Advisor?

Setting your investments on autopilot is not an investing strategy you can count on.

You need the experience and knowledge of a financial advisor or investment professional to help you make well-informed decisions about your investments. A pro will help you understand where your money is going and will answer questions you have about how your 401(k) plan works.

Your financial advisor may not get paid from helping you make decisions about your 401(k), since your 401(k) plan is sponsored by your workplace. Or they may choose to charge a one-time consultation fee. Regardless, you can ask on the front end to make sure there are no surprises.

If you want a solid retirement plan, work with a true pro to create a long-term strategy for your investments. You want a pro who is smarter than you but always knows you call the shots. After all, no one cares more about your retirement than you.

Need help finding a pro? With our SmartVestor program, you can find a financial advisor to help you understand your 401(k) and how it fits in your overall retirement plan.

Find a financial advisor today!

 

Ramsey Solutions

About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners.

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