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  • Valerie Smith

Understanding 401(k) Retirement Plans: What You Need to Know

A 401(k) is a retirement savings plan offered by an employer, allowing employees to save for retirement and invest part of each paycheck on a tax deferred basis. Employers may and often do elect to match a portion of the money employees contribute, up to a certain amount.

Participation in a 401(k) plan has tax advantages for both the employer and the employee:

  • The employer can take a tax deduction for its contributions to the plan when they match your contributions;

  • The employee pays taxes on employer contributions only when they are withdrawn at their time of retirement, or when they leave their job.

Enrolling in a 401(k) is generally very easy, and you do not have to be an investing expert.


Should you sign up for a 401(k)?


When you start a new job, you may be offered enrollment in your employer’s 401(k) plan. If a 401(k) is available to you, enrolling in it is a no-brainer. If your employer offers a match, think of this as free money offered to you. A second benefit of enrolling in a 401(k) is the immediate tax benefits – your year-end W-2 will have a lower taxable income, because you won’t pay taxes on the 401(k) contributions until you pull it out of your account in retirement.


When you enroll in your company’s 401(k), you will automatically be saving for retirement, essentially before you even get paid. In other words, you’ll be working on long-term goals before you have a chance to spend your money.


What are the drawbacks of enrolling in a 401(k)?


There are a few reasons why you may consider not enrolling in a 401(k).


  • · Less flexibility to access funds than a traditional IRA: A 401(k) has less flexibility than a traditional IRA if you need to withdraw your money. With a traditional IRA, you are allowed to withdraw up to $10,000 to use towards a first-time home purchase or higher education expenses for you, your children or grandchildren. With a 401(k), you would be subject to a 10% penalty. However, if you have to pay medical bills that exceed 10% of your income, the IRS will allow you to withdraw funds penalty-free. Some 401(k) plans allow you to take a loan on your funds, but this will depend on your employer and plan.

  • · Limited investment options: Depending on who administers your 401(k), you may have limited options for your contributions. You can select portfolios based on your likely retirement age or investment risk level, but you may not be able to invest in specific stocks, ETFS or mutual funds.

  • · High fees: You may not know it, but your 401(k) may be subject to investment fees, plan administration fees, and individual service fees. These may be significant. The Center for American Progress (CAP) found that the typical American worker who earns a median salary starting at age 25 will pay about $138,336 in 401(k) fees over their lifetime.


Despite these drawbacks, most financial advisors and retirement planning experts will agree that the benefits of enrolling in a 401(k) outweigh any drawbacks. Saving for retirement now will determine your budget and lifestyle in the years that you are unable to work.


How much can you contribute?


As of 2019, you can contribute up to $19,000 each year in your 401(k), or $25,000, if you’re over age 50 (known as the catch-up contribution limit). You can also contribute up to $6,000 of after-tax dollars in your Individual Retirement Account (IRA), or $7,000 if you’re over age 50.


If you have a 401(k), you can make changes to your contribution amounts at any time, not just during the open enrollment period.


What If you leave your job?


If you quit your job or change jobs, you may be able to keep your account where it is, an option usually available if you have at least $5,000 invested. You can also roll over the balance of your 401(k) into a new account with your new employer, into an IRA, or begin taking distributions (depending on your age), or cash it out entirely.


If you do withdraw your money as cash, you will automatically pay a 10% withdrawal penalty, and then federal taxes and state taxes (in some states) as income. For example, if you withdraw $10,000, you may pay $3,000 to $4,000 in taxes and penalties. If you wait until you are 59½ years old, you can take distributions from your account penalty free. Once you are 70 ½, you must withdraw a specific portion each year, or be subject to a 50 percent tax penalty on the Required Minimum Distribution (RMD), unless you continue to be employed at your employer. However, if you have old 401(k)s or IRAs, you will need to take the RMD from those accounts, even if you’re still working. If you plan to work past 70 ½, you may be able to avoid taking required distributions by rolling old accounts in your current employer’s plan.


How much money do you need for retirement?


Most people do not contribute the maximum 401(k) contribution limit, but you should try to save as much as you can. In 2013, CBS News published an article by Steve Vernon about the risks of living too long, specifically, the possibility of running out of money. Statistically, a 65-year-old couple has a 45 percent chance -- that one of them will live to age 90. One of the biggest challenges of planning for retirement is you have no idea how long you’ll live. Scour the internet and you’ll find numerous expert theories about how much money you need to save. The AARP will tell you conventional wisdom is between $1 to 1.5 million, or 10 to 12 times your current annual income. If you will be needing to financially support family members, you may need even more.


The easiest way to save for retirement


More and more Americans are approaching their retirement years unprepared. If you are one of the 20% of Americans that have nothing staved for retirement, make this the year that you eliminate yourself from that label. Enrolling in your company’s 401(k) plan at work is the easiest way to start saving. At the bare minimum, if your employer offers a match, take full advantage of that. You get 100% return on the amount you contribute, and the money can grow tax-free until you retire. Put a budget of your monthly expenses together and figure out what you can afford to contribute beyond your employer’s match, and save as much as you can.


Put excuses aside and put money away


It's easy to come up with reasons to not save for retirement, especially when retirement seems like decades or a lifetime away. Student loan debt, kids’ college savings, and just putting food on the table are all more immediate short-term priorities. But don’t lose sight of the long-term goal. Remember that the longer you put off getting started, the longer you will need to work, and the more likely you will not have enough money saved when you need to stop working.


As the famous 1789 quote attributed to Ben Franklin goes, “Nothing is certain except for death and taxes.” And in all likelihood, before death, there will be a point where you are no longer able to work. By starting to save for retirement now, you can make sure retirement is an enjoyable chapter of life, allowing you the funds and freedom to travel, volunteer, participate in hobbies, and financially help your family members.


All information and materials in this article are for educational purposes only. Opinions expressed in this article are based on information considered reliable, but The Daily Money Show cannot guarantee the accuracy of the information nor should it be relied upon. The information discussed in this article should not be used as a recommendation to buy or sell securities nor should it be taken as investment advice. The Daily Money Show is not a Registered Investment Advisor or Broker Dealer. The Daily Money Show is not an accounting firm and does not give tax advice regarding any security or real estate transaction. You may want to consult with an accountant, attorney, real estate agent or financial advisor before proceeding with any transaction regarding securities or real estate.

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