Guide

401(k) Basics: A Starter Guide to Understanding Your Retirement Plan

aAlthough it may seem similar at first glance, your 401(k) is very different from a traditional savings account. Between the rules that dictate how much money can be contributed to the plan and the differences between a Roth account and a traditional retirement plan account, understanding a 401(k) plan can sometimes be confusing. Below is a quick question and answer to some of the most common queries we receive from participants just like you.

What are the differences between a traditional and a Roth 401(k)?

The main difference is the tax advantage.

  • Traditional 401(k) contributions are made on a pre-tax basis and individuals pay income tax on the amounts withdrawn once they retire.
  • A Roth 401(k) benefit allows for after-tax dollar contributions. The selected amount will be deducted from your salary after Income, Social Security, and other applicable taxes withheld.

How is money deposited into my 401(k) plan?

After you meet the eligibility rules for your plan, there are two main ways to contribute money to your account:

  • Via your paycheck.
    • Once you decide how much you’d like to contribute to your 401(k), that percentage, or dollar amount, is deducted from your paycheck. Contributions are prepared through the employer’s payroll system and are deducted from each paycheck during the payroll period.
  • Via your employer contributions.
    • Some plans have something called “employer matching,” which means your employer will contribute to your account based on how much you contribute, up to certain limits set by the IRS or your plan document. For example, if your plan has a 4% match and you contribute 3%, your employer also contributes 3%. If you contribute 5%, your employer will contribute 4%.

What are the contributions limits for a 401(k)?

It depends.

  • For 2022, the maximum contribution to a 401(k) annually is $20,500 (indexed each year for inflation) regardless of whether the money is a pre-tax or Roth contribution (up from $19,500 in 2021). However, participants 50 years of age or older may contribute up to $27,000 annually.
  • $20,500 is the limit you can contribute from your own paycheck. If your plan offers employer matching, the amount of your employer contribution will be added to your own contribution.

How much should I contribute to my 401(k)?

It varies depending on your personal financial situation.

  • This is a decision for you alone based on your other investments, your tolerance for risk, how much income you think you will need during retirement, and many other factors.
  • There are many tools that can help you. Consider using the 401(k) calculator by selecting one of several options available online.
  • The most important thing you can do is start saving now. The effect of growth over time can have a significant impact on your accumulated savings due to the accumulation of interest, dividends, capital gains and investment returns. For example, Mary saves $250 a month starting at age 28 and Marco saves $250 a month starting at 35. *Assuming a tax-deferred annual rate of return of 7.00% per month, both Mary and Marco retire at age 67 and the difference in Their savings is $254,000** although there is only a $21,000 difference in total 401(k) contributions.
retirement contributions

*This hypothetical scenario is for illustrative purposes only and is not intended to represent the performance of any specific investment. Past performance is not indicative of future results. Actual returns will vary and principal will fluctuate. Taxes are due on conventional contributions at the time of withdrawal. Performance is not guaranteed for any investment.

**Assuming a 7% growth rate, compounded per month with each monthly payment occurring at the beginning of the period. Numbers are rounded to the nearest thousand.

What is the contribution of the overhang?

Funds from your retirement plan account with a former employer or an Individual Retirement Account (IRA).

  • An overnight contribution refers to money you moved from your previous employer’s retirement account or other eligible plan to your new employer’s retirement account. If your plan accepts rollover funds, you can consolidate your retirement accounts by transferring assets from those other accounts. For example, if you previously had funds left in a retirement account with ABC Retirement and started a new job with an employer with an account with XYZ Retirement, the movement of that money from the previous provider to the current provider is referred to as the “overnight contribution.”

What are the different ways to withdraw money from my 401(k) account?

There are several different ways to get money from your account depending on the features your plan offers.

  • First, know the basics.
    • Your 401(k) is intended to be used after you reach retirement age. To discourage early withdrawal of retirement plan funds, withdrawals before you reach the age of 59 are subject to tax withholding and early withdrawal penalties. Participants are also required to begin making withdrawals when they reach the age of 72, which are referred to as Minimum Required Distributions (“RMDs”).
  • via Minimum Required Distributions (RMDs).
    • RMDs are the minimum amount you must withdraw each year from a retirement plan after you reach age 72. However, as stated on the IRS website, Roth IRAs “do not require withdrawals until after the owner’s death.” *
    • * There are exceptions to this rule for participants who own a certain percentage of the business.
  • across hardship distributions.
    • Participants may be able to withdraw funds if they can demonstrate a significant financial need. The IRS allows withdrawals for certain types of “significant financial need,” but generally this type of withdrawal is intended to cover medical expenses, funeral expenses, and similar emergencies. Unlike a loan, the withdrawal is not required to be repaid due to hardship.
  • through loans.
    • A 401(k) loan is a way to borrow against your retirement account while agreeing to repay the balance, plus interest, within a specified time frame. Loans generally have a term of 1 to 5 years, although your plan may allow for a longer term if you use the loan to purchase a primary residence. You must pay off your loan through deductions from the payroll or repay it in full with a lump sum payment.
    • Participants can take out a “loan” from the balance earned in their plan. The IRS limits the loan amount to more than $50,000 or 50% of the participant’s earned account balance. There may be limitations in the plan, such as the number of loans one participant can have or the number of loans the plan can have at any one time through all participants.

For information about 401(k) retirement and other workplace savings plans, visit vestwell.com

This article was originally published on Vestwell.

The opinions and opinions expressed here are those of the author and do not necessarily reflect the views and opinions of Nasdaq, Inc.

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