What is a 401(k)?
A 401(k) is an employer-sponsored, tax-advantaged retirement account. There are two primary types:
- Traditional 401(k): Contributions are made pre-tax, reducing taxable income now, but withdrawals in retirement are taxed.
- Roth 401(k): Contributions are made after-tax, so withdrawals (including growth) in retirement are tax-free.
Employers often match contributions, which is essentially free money added to your retirement savings.
How Does a 401(k) Work?
- Contributions: Deducted automatically from your paycheck.
- Investments: Funds are typically invested in options like mutual funds or target-date funds offered by your plan provider.
- Growth: Money grows tax-deferred (traditional) or tax-free (Roth).
- Withdrawals: Funds are accessed during retirement, with specific rules for each 401(k) type.
401(k) Contribution Limits
| Limit Type | Amount |
|------------------------------------|------------------|
| Employee Contribution | $23,000 |
| Catch-Up (50+) | Additional $7,500|
| Employee + Employer Combined | $69,000 (under 50) or $76,500 (50+) |
Benefits of a 401(k)
- Higher Contribution Limits: Exceeds limits of Individual Retirement Accounts (IRAs).
- Employer Match: Free contributions from your employer.
- Tax Advantages: Tax-deferred or tax-free growth depending on account type.
- Automated Saving: Contributions directly from your paycheck.
Drawbacks of a 401(k)
- Limited Investment Options: Compared to IRAs, choices may be restricted.
- Fees: Higher administrative fees than other retirement accounts.
- Withdrawal Restrictions: Early withdrawals face penalties unless specific criteria are met.
Traditional 401(k) vs. Roth 401(k)
| Feature | Traditional 401(k) | Roth 401(k) |
|---------------------------|---------------------------------------|---------------------------------|
| Tax Treatment | Contributions reduce taxable income now; withdrawals taxed in retirement. | Contributions are after-tax; withdrawals (including growth) are tax-free. |
| Required Minimum Distributions (RMDs) | Start at age 73. | No RMDs (if rolled into a Roth IRA). |
| Best For | Those who expect to be in a lower tax bracket in retirement. | Those who expect to be in a higher tax bracket in retirement. |
401(k) Withdrawal Rules
- Qualifying Withdrawals: At age 59½, with certain disabilities, or hardship withdrawals.
- Early Withdrawals: Subject to a 10% penalty and income tax unless exceptions apply.
- RMDs: Begin at age 73 for traditional accounts. Roth 401(k)s are exempt.
- Emergency Withdrawals: Starting in 2024, up to $1,000/year without penalty for emergencies (must be repaid within three years).
What Happens If You Leave Your Job?
Options include:
1. Roll Over: Transfer funds into a new employer’s 401(k) or an IRA (typically tax-free if done within 60 days).
2. Leave It: Keep funds in your old employer’s 401(k) but no longer contribute.
3. Withdraw: Take the money (subject to taxes and penalties if early).
Key Next Steps
- Aim to contribute 10%-15% of your income or enough to get the full employer match.
- Consider both a 401(k) and an IRA for a diversified retirement strategy.
- Use NerdWallet’s 401(k) calculator to estimate your future balance.
A 401(k) is a cornerstone for building a solid retirement plan. Take advantage of any employer match, contribute regularly, and choose investments aligned with your goals!
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