Breaking Down a 401k

Planning for the future can be stressful, but it is necessary. Luckily, a 401k can help to reduce the stress of retirement and put your mind at ease about the future.

So what is a 401k?

A 401k is a retirement plan that allows employees to save and invest for their retirement on a tax deferred basis, as long as you meet the requirements. An employer, also known as the plan sponsor, is allowed to sponsor a 401k for their employees. Each employee chooses how much money they want deducted from their paychecks and deposited to the plan based on limits imposed by plan provisions and IRS rules.
How does it work?

When you choose to defer some of your current salary to put in the plan, it is called a salary deferral contribution. Money that grows in the plan will become tax-deferred. This means that as investments earn investment income, you do not pay tax on the investment gains each year. Employers have the option to contribute to your 401k or match what you contribute, though they are not required to do so.
Important things to remember:

  • Don’t put off participating in your 401k. Time is the best way to guarantee that you will meet your retirement goals.
  • When your sponsor gives you a Summary Plan Description, read it. Within this, you will find how your plan works, what options are available, who the trustees are and tons of other helpful information.
  • A 401k is not a savings account, do not rely on it in the case of an emergency. There are some plans that will allow you to take out a loan or hardship withdrawals, but they are very restrictive.
  • Once you begin contributing to your 401k plan, these funds are not available for withdrawal generally until you are 59 ½ . Should you withdraw these funds prior to that age, you will be subject to a 10% penalty as well as the income tax on the amount withdrawn.

When making contributions, it is important to remember to stay within the legal limits. The IRS guidelines limit you to contributing a maximum of $19,500 to a 401k in 2020. However, if you are 50 years or older, you can put in an additional $6,500 in “catch-up” contributions.

Although it can be overwhelming, it is important to begin planning for the future as soon as possible. Creating a plan and staying on track can help you reach your retirement goals.