What is a 401k?
A 401k is an employer-sponsored retirement account. It allows an employee to dedicate a percentage of their pre-tax salary to a retirement account. These funds are invested in a range of vehicles like stocks, bonds, mutual funds, and cash.
How does a 401k work?
A 401k plan is a benefit commonly offered by employers to ensure employees have dedicated retirement funds. A set percentage the employee chooses is automatically taken out of each paycheck and invested in a 401k account. They are made up of investments (usually stocks, bonds, mutual funds) that the employee can pick themselves.
Depending on the details of the plan, the money invested may be tax-free and matching contributions may be made by the employer. If either of those benefits are included in your 401k plan, financial experts recommend contributing the maximum amount each year, or as close to it as you can manage.
What are the benefits of a 401k
401 tax benefits are hard to dispute, as they can offer workers a lot of financial security, including:
- Employer match
- Tax breaks
- Shelter from creditors
- Let’s dig in a littler deeper.
401k employer match
Do you like free money? Good, now that we’ve got that out of the way, a company-matched 401k is basically that. Many employers offer to match employee contributions, either dollar for dollar or 50 cents to the dollar, up to a set limit. So, for example, say you make $100,000 a year (#baller) and your employer offers a 401k matching of 50% up to the first 6% you elect to contribute. If you contribute 6% of your annual earnings ($6,000), your employer would contribute an additional 50% of that amount. So, 3,000 free dollars.
It’s up to your employer to decide what percentage they will match, but many companies do offer a dollar-for-dollar match.
401k tax breaks
The tax benefits of 401ks are like the triple-crown of finances. First, contributions are pre-tax. You don’t pay taxes on the money until you withdraw it when you retire. (At the earliest, this is age 59.5.)
Second, your 401k contributions are not counted as income, which could put you in a lower tax bracket. The result: your tax bill will be smaller for your having squirreled away money for your later years.
Third, your savings grow tax deferred. In a regular investment account, your net gains and dividends would be taxed. But in a 401k plan, your money grows tax free as long as it stays in the plan. This allows your earnings to compound — which is just a fancy way of sayings, your earnings will earn earnings.
401k shelter from creditors
If your finances take a turn for the worst, you won’t have to worry about creditors coming for your 401k. Your qualified retirement plan is protected by the Employee Retirement Income Security Act of 1974 (ERISA) from claims by judgment creditors.
What is the maximum 401k contribution for 2020?
That depends on your employer’s plan. But, good news ya’ll. The maximum the IRS allows for 2020 is up from the previous year. Currently the cap sits at $19,500 but your employer may cap the amount below that. For people over 50 the maximum increases to help them “catch up” before their retirement. They can contribute an additional $6,500 a year.
What happens to my 401k if I change jobs?
You have a couple options, but the one most would recommend is a 401k rollover. A 401k rollover is when you transfer your funds from your employer to an individual retirement account (IRA) or to a 401k plan with your new employer. A much less popular option is to cash out your 401k, but this comes with massive penalties; income tax and an additional 10% withholding fee.