The history of the most common American retirement plan — the workplace 401(k) — is long, but the essential idea is simple.
Save money today and lower your current income taxes. Put in pre-tax money while you are working and take money out later, and pay the income taxes when you take money out in retirement. Enjoy tax-free compounding growth on that money in the meantime.
So how do they work? First of all, the generic phrase “401(k)” covers a variety of workplace plans with slightly different names: 403(b), 457, and so on.
All of these plans do the same thing in the same fundamental way: Your employer deducts money from your paycheck and sends it to an investment company.
How much is up to you, but many plans today start by taking at least 3% of your pay unless you opt out.
The upper limit on annual savings contributions to your plan, however, is expressed in dollars.
For 2019 the figure is $19,000, plus an extra $6,000 if you’re age 50 or older, the “catch up” provision for a worker nearing retirement age. This dollar limit usually adjusts upward each year.
Your employer might choose to match a certain portion of your savings. A common matching formula is $0.50 for each $1 you save up to 6% of your pay.
The match is an incentive for you to start saving in a 401(k) plan but also an incentive to stay with your company. Typically it takes four years until you’re “vested” in the plan, meaning the extra matching dollars are yours to keep.
In addition, matching money doesn’t count against your annual contribution limit.
If the money in your 401(k) is invested prudently, it grows and compounds tax-free. The plan shields your invested savings both from current income taxes and from investment taxes.
That’s a huge boost, one that can add dramatically to your balance over time.
Yes, you ultimately will be taxed on your 401(k), but only when you take money out in retirement and only at your income tax rate then.
Meanwhile, money you don’t take out for living expenses continues to grow, free of investment taxes.
Importantly, money you save into your 401(k) is taken from your check before the income tax is applied (you’ll see it called “pre-tax” on your pay statement).
As a result your actual income is lower, so your federal and state income tax bill also should be lower.
If you are estimating how much you can afford to save, that tax savings “bump” might mean you can get closer to your goal without diminishing the take-home amount in your check.
What’s more, 401(k) plans are “portable,” meaning you can take your money to your next employer or roll it over into an IRA without paying penalties or taxes.
Unlike a pension, your 401(k) savings, investment earnings, and any vested matching is held in account in your name.
One important rule to remember: The IRS charges a 10% penalty on withdrawals made before age 59 ½, with a few narrow exceptions.
You also must pay current income taxes due on any money taken early from the plan.
Eventually, of course, the government wants its tax money. So, beginning at age 70 ½ you will be required to take out money on an annual basis, whether you need it or not.
These are known as required minimum distributions (RMDs).
RMDs are calculated using a longevity table published by the IRS. Since an RMD is income, you are taxed at your current income tax rate on this once-a-year distribution.
So, you max out your 401(k), get the company match, and all is well. Are you done?
Of course not, there’s more. There are a variety of other tax-advantaged retirement plans, such as as IRAs, Roth IRAs and Roth 401(k)s. We will cover these in separate guides.
For any given individual, of course, the actual numbers get complex. This explanation is only meant as a top-level guide to how 401(k) plans work in general.
A good financial planner can help you maximize the effectiveness of your retirement plans you and make sure that you stay on track for retirement.
The goal of a solid financial plan is to retire with no surprises and have a comfortable income to show for years of saving.