Saving for retirement is one of the best things you can do for your future. However, 50% of Americans surveyed won’t be able to cover their expenses in retirement (source).
If you’re worried about not having enough money to sail into your golden years, you might be considering a 401(k) plan. But is it the right retirement account for you? Here’s what you need to know to help you decide.
What is a 401k retirement plan?
A 401(k) plan is a retirement account available to you through your employer. Only 11% of 401(k) plan participants don’t receive employer contributions to their plan. You make contributions to the account through payroll deductions. That money is then invested in different stocks, bonds, or mutual funds.
401(k) plans were first implemented in 1984. They gave Americans the chance to save for their retirement directly from their paychecks. As of 2018, 401(k) plans hold over $5.3 trillion in assets for 55 million active participants and millions more of former employees and retired workers (source). 401(k) plans are the largest and most common employer-sponsored defined contribution plan in the United States. They are used by households with all types of income levels. In 2016, 60% of households with a 401(k) had an income of $75,000 or less; and 43% made less than $50,000 (source).
Depending on the type of employer you work for, this retirement account can also be called a 403(b) or a 457(b). The name may be different, but these accounts all operate in the same way. We’ll use 401(k) as the general name to describe how these retirement accounts work.
How a 401k plan works
A 401(k) is a great tool because it offers a way for you to automate tax-advantaged savings for retirement. If you are eligible for your employers 401(k) plan, you can sign up and choose how much money you’d like to have deducted from each of your paychecks.
The money invested in your 401(k) is done so with pre-tax dollars, meaning you haven’t paid tax on the money that you’ve used to invest. You can invest the money how ever you choose and it will grow over time to help fund your future retirement.
Once you hit retirement age, you’ll start taking distributions from the 401(k). Since you don’t pay tax on the money when investing it, you’ll pay once you start receiving distributions.
401k plan eligibility
Unfortunately, not every employer offers a 401(k) plan. 42% of private sector workers don’t have access to a 401(k) plan through their employer.
If your employer offers a 401(k) plan, they’ll have information about who is eligible to participate in the plan. The IRS requires that employees 21 years or older who have worked for the company for at least one year be allowed to participate in the plan.
If you are self-employed, you may still be able to contribute to a one-participant 401(k) plan, also known as a solo 401(k). To be eligible, your business must have no employees other than yourself and your spouse.
What are the benefits of a 401k plan?
There are four main advantages of using a 401(k) plan for your retirement.
One of the best benefits of a 401(k) is the tax advantage it provides. You only pay taxes when you take money out of the account. Through payroll deductions, you are able to invest money in the account with pre-tax dollars.
This money will grow and compound over the years and you’ll only pay taxes once the money is distributed to you, which is presumably in retirement.
Another big benefit of 401(k) plans is that employers often contribute to your account by matching a portion of your contributions. You can think of this as free money that your employer is also adding to your retirement.
To illustrate, let’s say that you earn $100,000 per year. Your company has said that they will match your contributions into your 401(k), up to 4% of your salary. That means, if you put $4,000 into your 401(k), your employer will also put $4,000 into your 401(k).
If you decide to put $10,000 into your 401(k), your employer will still contribute $4,000 as the max they will contribute is 4% of your salary. In 2016, the average 401(k) company match was 4.1%.
Loan and hardship withdrawals
While the money you put into your 401(k) account is meant to be used during retirement, you can access it early if needed. If you’re in need of money earlier, you can see if you qualify for a hardship withdrawal or a loan from your 401(k). We cover those two options in more detail below.
Once you leave your employer, you have the flexibility to decide what to do with the money in your 401(k). The ability to decide what to do with your 401(k) means you can choose the best option for you.
As of 2020, the government allows you to contribute $19,500 annually to a 401(k). If you are 50 or older, you can add an additional catch-up contribution of $6,500 annually.
IRA vs. 401k
You may be wondering whether a 401(k) is better or worse than an individual retirement account (IRA). Fortunately, you don’t have to choose between the two. You can have both a 401(k) and an IRA as long as your income allows you to qualify for the IRA.
There are two main benefits of a 401(k) that make it a more appealing option than an IRA: the employer contribution and the higher contribution limit.
If your employer offers a 401(k) match, that is free money that they are giving you when you participate. An IRA is not offered through an employer, so there is no contribution match.
If you’re looking to save as much money as possible for retirement, you can contribute more to a 401(k) than an IRA. In 2020, the contribution limit of an IRA is $6,000. That is much less than the 401(k) contribution limit of $19,000.
Again, you don’t have to choose between the two retirement account options. Investing in both is a great option if you are eligible and can afford to do so.
Can you withdraw the money early?
The best idea is to think of this money as completely untouchable until retirement. That’s what you’ve been putting it away for, right? But there are times when you need to access the money before retirement, and the 401(k) offers options to make that possible.
Cash out and pay tax and penalty fees
This is the worst option for accessing your funds. If you need to take the money out before retirement age and you don’t qualify for a hardship withdrawal, it will cost you. You’ll be stuck paying a 10% penalty fee in addition to the tax on your withdrawal.
Some plans may offer a loan from your 401(k), but there are drawbacks to taking the loan that you should consider:
- If you don’t repay the loan, it will be treated as a distribution from your 401(k) and you’ll be stuck paying the 10% penalty fee and taxes.
- There are strict limits. The loan amount can’t be more than 50% of your vested balance, up to a maximum loan amount of $50,000.
If your employer doesn’t offer a 401(k) loan, they may offer access to your money through a hardship withdrawal.
To be considered a hardship, you:
- Must have an immediate and heavy financial need
- Can’t withdraw more money than you need
- Can’t have other resources that you can use to meet that need
What does a heavy financial need mean? It can include:
- Certain medical expenses
- Costs relating to the purchase of a primary residence
- Tuition and related educational fees
- Payments necessary to prevent eviction from, or foreclosure on, a principal residence
- Burial or funeral expenses
- Expenses related to the repair to your primary residence
If your plan offers a hardship withdrawal, they will have information on what you’ll need to provide to prove the hardship expense. Unlike a loan, you won’t repay the distribution from the hardship withdrawal.
This means your 401(k) account balance will be permanently decreased. In addition, you won’t be able to make contributions to your 401(k) for six months following your hardship withdrawal.
Options when you change employers
A 401(k) offers flexibility when you leave your employer. There are four options available to you:
Cash out and pay penalties
This is the worst option available. You’ll be stuck paying the 10% penalty fee as well as taxes immediately upon taking money from your 401(k). The even bigger financial pitfall is that your money is no longer invested and growing tax-deferred. You could end up losing out on decades worth of investment growth
Keep your 401k with your former employer
You’re allowed to keep your 401(k) with your former employer, but that might not be your best option. You may be charged additional administration fees that you weren’t charged as an employee. These fees can eat away at your return.
Roll over your 401k plan to your new employer’s plan
Assuming that you have a new job lined up and your new employer offers a 401(k) plan, you’ll be able to roll over your old plan into your new employer’s plan. You’ll want to review plan investment options and fees to ensure it’s the right move.
Roll over your 401k plan to an IRA
You also have the option to roll over your 401(k) plan to an IRA. This is usually a smart option for people who want to minimize fees as well as have a more diverse set of investments available to them.
When you roll over your 401(k) into an IRA, your money keeps growing tax-deferred and you can choose any investment advisor that you like. You can find a full guide on how to roll over your 401(k) to an IRA here.
Compare 401k plans before you make a decision
401k plan fees can reduce the returns of your retirement plan considerably. Compare fees and services when choosing a 401k plan. Fees fall into three categories: investment, administrative, and individual service fees.
The investment fee is the largest fee you will pay. These fees should be disclosed in fund prospectuses and annual reports, cover the cost of managing the investments.
Mutual funds may also charge a load, an industry term for a sales charge or commission. This is a front-end load, which means you pay for it upfront. Or, it may be paid when the shares are sold, known as a back-end load or redemption fee. Many funds will waive sales charges for 401k plans.
If you’re ready to get started saving for retirement and you’re looking for the right investment advisor, be sure to compare your brokerage options side-by-side to find your best option.
Andrew is the managing editor for SuperMoney and a certified personal finance counselor. He loves to geek out on financial data and translate it into actionable insights everyone can understand. His work is often cited by major publications and institutions, such as Forbes, U.S. News, Fox Business, SFGate, Realtor, Deloitte, and Business Insider.