A Beginner’s Guide to Understanding 401k

Published: Feb 26, 2018 10:00:00 AM

The word 401k is synonymous with retirement, but how many of us actually know all the rules around 401ks? We've made this FAQ to walk you through all the basics.

What is a 401k?
A 401k is an employer-sponsored type of retirement plan. It allows an employee to dedicate a percentage of their salary to a retirement account. Retirement accounts, in general, are a combination of savings and investment accounts. Contributions are tax-free and taxes are paid upon withdrawal.

How does a 401k work?
A 401K plan is a benefit commonly offered by employers to ensure employees have money to retire with. A set percentage is automatically taken out of each paycheck and invested in a 401k account made up of investments (usually stocks, bonds, mutual funds) that the employee can pick themselves.

Depending on the particulars of the plan offered by employers, the money invested may be tax-free and matching contributions may be made by the employer. If either of those benefits are included in your 401k plan, financial experts recommend contributing the maximum amount each year, or as close to it as you can manage.

What is the maximum 401k contribution for 2018?
That depends on your employer's plan. The maximum the IRS allows for 2018 is $18,500, but your employer may cap the amount below that. For people over 50 the maximum increases to help them "catch up" before their retirement. They can contribute an additional $6,000 a year.

What happens to my 401k if I change jobs?
You have a couple options, but the one most would recommend is a 401k rollover. A 401k rollover is when you transfer your funds from your employer to an individual retirement account (IRA) or to a 401k plan with your new employer. A much less popular option is to cash out your 401k, but this comes with massive penalties; income tax and an additional 10% withholding fee.

What is an IRA?
While there are lots of benefits to 401ks, they're not the only retirement plan in the game. An IRA is an individual retirement account. Where a 401k can only be offered through an employer, an IRA account can be opened up by an individual whether they're associated with an employer or not. That means they're the best option for independent contractors without an employer or anyone who wants to do some extra retirement planning on top of their 401k.

What is a Roth IRA?
A Roth IRA is a type of individual retirement account similar to traditional IRAs in many ways, but with some significant differences. One of the main differences is how the tax breaks are different: with a traditional IRA, the money you put in isn't taxed; with a Roth IRA the money you take out (once you've reached retirement) isn't taxed. Roth IRA's also have no requirements on when the money must be taken out, so they can be a good tool to pass along wealth to your beneficiaries if you find you don't need the money in retirement.

What are the Roth IRA rules?
Roth IRAs are only available to people making less than $129,000 a year as an individual, or $191,000 for married couples. They have contribution limits $5,500 a year, or $6,500 for those over 50. Unlike 401ks and traditional IRAs though, there's no penalty for withdrawing part of your contribution early. 

What are the traditional IRA contribution limits?
A traditional IRA has the same contribution limits as a Roth IRA: $5,500 for most people, $6,500 for anyone over 50.

How is an IRA different from 401k?
401K accounts are associated with your employment, as contributions are taken out of your wages before taxes. A traditional IRA is similar to a 401k in that contributions aren't taxed (they are deductible), but the key difference is that they are independent of your employer. A Roth IRA is also independent, but contributions are made after taxes. Withdrawals from your Roth IRA are tax free, which makes them a smart choice if you think taxes will be higher in the future.

When can you withdraw from your 401K without a penalty?
59 and 1/2 is the current age when you can take money out of your 401k without incurring a penalty. However, the money you take out is still taxed as income. At the age of 70, you will be forced by the IRS to start taking distributions from your retirement accounts.

What are the penalties if I cash out my 401k early?
If you withdraw funds from your 401k before the age of 55 and 1/2, then you will pay a 10% early withdrawal penalty and taxes on all the funds. This adds up. Assume you have $250,000 in your 401k and you want to take it out early. After penalties, you will have around $180,000. A loss of $70,000.

Are there other kinds of retirement accounts?
401k and IRAs are the main two. There are a couple of other types available to small business owners or the self-employed: SEP IRAs and Simple IRAs. 

This article was originally published by KASASA on their blog and published here with permission.

Written by KASASA