What is a 401(k)? What to know about this retirement investment vehicle

Retirement Account Statement
When it comes to contributing to a 401(k), it’s important to do your research first.

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If you work for a private company, one of the easiest ways to save for retirement is a company-sponsored 401(k) plan.

A traditional 401(k) ⁠, named for a subsection of the US tax code ⁠, is a retirement plan offered by many employers. Employees elect to have a pre-tax percentage of their earnings withdrawn and deposited into the account. Employers often offer a selection of stocks, bonds, cash, mutual funds, and other investments.

Here’s what you need to know about your retirement savings account.

How much of my income should I put into my 401(k)?

Most financial experts recommend that you contribute 10% to 15% of your income, including employer contributions, called “matching” funds, to your 401(k). Many banks or financial websites offer easy-to-use retirement calculators, as does the Department of Labor.

Many employers offer what is called a matching contribution as an employee benefit, but the percentages vary. Let’s say your employer offers 401(k) contributions with a 50% “match.” That means if you contribute $10,000 per year, your employer’s contribution will be $5,000, so you’ll end up with $15,000.

How is a 401(k) plan taxed?

There are two main types of 401(k) plans: traditional and Roth.

  1. Traditional: You do not pay federal income taxes on a traditional Contributions to the 401(k) plan until you withdraw from the account. That means investments grow tax-free.

  2. Roth: Contributions to a Roth 401(k) are made on an after-tax basis. When you withdraw, the funds will not be taxed because you contributed after-tax income.

An individual retirement account (IRA) is opened by an individual, usually through an investment firm, bank, insurance company, or broker. An employer opens and manages a 401(k). Under IRS rules, contribution limits are higher for a 401(k) than for an IRA.

The limit for employer-sponsored 401(k) plans in 2022 is $20,500 after the IRS raised the limit by $1,000 last year. That’s much higher than the $6,000 maximum for traditional and Roth IRAs.

Can you withdraw money from your 401(k) account without penalty?

In general, taking money out of a retirement plan before you turn 59½ carries a penalty. The IRS calls this move an early or “premature” distribution. You’ll end up paying a 10% tax on the early withdrawal unless you qualify for an exception.

Can you get a loan against your 401(k) plan?

If your plan allows it, you can borrow up to $50,000 or half of your vested balance. Most plans give borrowers up to five years to repay the loan, with interest.

Be careful, though: If you lose your job and don’t pay by that year’s tax due date, the IRS considers your loan a withdrawal. That means if you’re under 59½, you may have to pay the 10% early withdrawal tax penalty.

What happens to my 401(k) if I change jobs?

Most payments to your 401(k) plan can be “rolled over” to another 401(k) plan or an IRA within 60 days. You can ask your financial institution or the plan administrators to transfer the payment directly. Generally, you won’t pay taxes on the funds until you withdraw from the new plan.

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