The Basics of 401(k) Plans: How They Work
401(k) plans are a popular retirement savings option for many Americans. They are tax-advantaged plans that allow employees to set aside money for their retirement, and employers may even offer matching contributions. But how do 401(k) plans work, and what do you need to know to take advantage of them?
First, it’s important to understand the different types of 401(k) plans. There are two main types: Traditional 401(k)s and Roth 401(k)s. With a Traditional 401(k), you contribute pre-tax dollars, meaning the money is taken out of your paycheck before taxes are calculated. This reduces your current taxable income, which can result in lower taxes in the current year. With a Roth 401(k), you contribute post-tax dollars, meaning the money is taken out of your paycheck after taxes are calculated. This means you’ll pay taxes on your contributions in the current year, but your withdrawals in retirement are tax-free.
Next, it’s important to understand the contribution limits of 401(k) plans. For 2020, the maximum contribution limit is $19,500, or $26,000 if you’re age 50 or older. It’s important to note that this limit applies to all of your 401(k) accounts combined, so if you have multiple accounts, you’ll need to make sure you’re not exceeding the limit.
It’s also important to understand the rules for withdrawals from 401(k) accounts. Generally, you can’t make withdrawals until you’re 59 ½ years old without paying a penalty. If you do make a withdrawal before then, you’ll generally have to pay a 10% early withdrawal penalty, in addition to any taxes you owe on the withdrawal. You can also take out a loan from your 401(k) without penalty, but you’ll need to pay it back with interest.
Finally, it’s important to understand the rules for employer matching contributions. Many employers will match a portion of your contributions, up to a certain amount. For example, if your employer offers a 50% match up to 6% of your salary, if you contribute 6% of your salary, your employer will contribute an additional 3%. This can be a great way to boost your retirement savings, so it’s important to understand the rules and take advantage of any matching contributions your employer offers.
Understanding the basics of 401(k) plans and how they work can help you make the most of your retirement savings. From understanding the different types of plans and contribution limits to understanding the rules for withdrawals and employer matching contributions, it’s important to know the basics of 401(k)s to make sure you’re taking full advantage of them.