A 401(k) is a financial plan that helps people save for retirement and is provided by an employer. It allows employees to save and invest some of their pay before taxes are taken out. An employee’s contributions are deposited into a 401(k) account, and the employee often selects investments from a list of those available. The company may contribute to the employee’s retirement plan by, for example, matching the employee’s contributions up to a predetermined percentage. The government sets limits on 401(k) contributions annually and is adjusted for inflation. In 2022, the IRS’s maximum allowed was $20,500.
Before the 1980s, most employers offered pension funds to provide financial security to former employees. Pension plans work by providing retired workers a regular income from pension funds that the company oversees. As pension costs continued to rise, more companies began offering 401(k)s instead, a new type of retirement plan as an alternative to traditional pensions. Today, pensions are only offered for select government jobs and union jobs with significant bargaining power.
Many 401(k) plans allow you to decide how your retirement savings are invested or distributed. For the most part, 401(k) plans offer participants various mutual funds from which they can choose to invest in equities, bonds, and money markets, depending on the choices made available by the plan administrator. In addition, your assets increase without incurring taxes; you’ll only have to pay taxes when you cash out your 401(k). Even better, the contributions you make will lower your annual taxable income.
Some companies will match your 401(k) contributions up to a specified percentage of pay. A typical practice for employers is to contribute up to 3% of an employee’s income by matching the employee’s contribution dollar for dollar. Think about how much of an impact an employer match of 3% for someone with a salary of $60,000 yearly. In this case, your employer will match your contributions up to 3% of $60,000, or $1800. You can contribute more than this amount. However, your employer’s contributions will be capped when they have reached the percentage threshold. Another common practice is businesses that contribute fifty cents for every dollar (up to a specified total percentage cap) the employee adds.
A 401(k) plan can be a helpful saving tool, but it has several significant limitations. You must be employed by the employer for a certain period (the “vesting period”) before you are eligible to receive contributions made by the company to your 401(k) plan, so while employer-contributed funds are usually not instantly available, your own contributions are immediately vested. Taxes are due once funds are taken from the account. Additionally, there are intricate regulations about withdrawal timing, and early withdrawal is penalized heavily, including a 10% tax charge.
Financial planning for retirement might be complicated, but it doesn’t have to be. Visit IRS.gov for help picking and maintaining a plan that works for you. Don’t forget to check out our blog to explore more topics in career advancement and planning.