What is a 401(K)?

A 401(k) is an employer-sponsored retirement contribution plan that is often offered as part of a company’s benefits package. Employees, even low income households or single mothers, can contribute a small portion of their salary to a 401(K), even 1% of their income. The employer will often match a portion of the contributions. It is a retirement plan that is a great option for low income families as the contribution can be very minimal (even a dollar or two) and not only that, but many employers will match that investment (or a portion of it) as well. A 401K can in effect be “free money” for retirement.

This article covers everything you need to know about a 401(k), its main components, and why you should run to your HR department to turn in your paperwork if you are eligible.

What Is a 401(k) Plan?

A 401(k) is a qualified savings plan that receives special tax benefits from the IRS. Employees can contribute a fixed amount or percentage of their income. Even 1% of income can be contributed, and this is why the 401K retirement plan can be a great option for those who are struggling to pay the bills, as the needed contribution is minimal.

401(k)s come in “traditional” and “Roth” flavors. The funds in a traditional plan are not taxed until the money is withdrawn from the account. Contributions are made with pre-tax income, which means you can use a traditional 401(k) to lower your overall taxable income.

The Roth version of a 401(k) requires you to immediately pay income tax on your contributions. After retirement, you can make withdrawals from your account with no further taxes due. Choosing a Roth 401(k) makes sense if you have reason to believe you will be in a higher tax bracket when you reach retirement age. It’s a great choice for young workers who are just starting their careers and are in a low tax bracket.

Contribution Limits

The biggest advantage of contributing to a 401(k) is that it is automatically deducted every month once you sign up. It can be a great retirement plan for budgeting and also the pay yourself first concept. You get to choose whether it’s a fixed amount or percentage, so you’re always in control of how much you contribute based on your investment goals.

However, there are contribution limits. Whether it’s a traditional or Roth 401(k), the IRS sets annual limits on contributions that are updated regularly based on inflation. The maximum amount employees can contribute is significant ($20,000 or more) and people over the age of 50 can contribute more each year thanks to additional “catch up” contributions.

The maximum joint contribution by an employer and employee is in the $60,000 per year range (adjusted for inflation). While that maximum is not a concern for the vast majority of people, especially low income families, it is good to keep in mind.. The limited goes up for employees over 50. At a minimum, consider contributing the percentage your employer is willing to match, because every dollar matched is a 100% gain for you. You can adjust your contribution amount as often as your employer’s plan allows. You also have the option to opt-out of making contributions completely at any time, for whatever reason.

Investment Options for 401(k)

Financial institutions that administer 401(k) plans give participants several investment options, including mutual funds, index funds, bonds, and exchange-traded funds (ETFs). Employees have the freedom to choose how much of their account balance is invested in different types of funds. For example, you could choose to invest 70% in equity, 20% in a mutual fund, and 10% in a bond fund.

Plans that automatically enroll employees almost always invest contributions in so-called “target-date” funds. These are funds composed of a mix of stocks and bonds whose distribution is determined by an employee’s age and target date for retirement. You are always free to rebalance your investments if you’re not happy with the choices made by a target-date fund.

When to Withdraw

Rules set by the IRS prevent employees from withdrawing the funds in a 401(k) without penalty until age 59½. With some exceptions, withdrawals made before that age are subject to a 10% tax penalty, plus a 20% mandatory income tax if the amount is withdrawn from a traditional 401(k).

Once you turn 59½, you can opt to start taking distributions from your account. You must start withdrawing funds by age 72. There is a required minimum distribution (RMD) based on your age and account balance. Every year, you have the option to withdraw RMD as a lump sum or a series of staggered withdrawals. Remember, RMDs from a traditional 401(k) count as taxable income, while RMDs from a Roth account are tax-free.

There are a few triggering events that allow you to make early withdrawals without the penalty. These events include:
• Hospital bills that go over 7.5% of your gross income
• Permanent disability
• Getting laid off, quitting, or retiring at age 55 or older
• The 401(k) plan is terminated

There are also a variety of hardships outlined under the plan (e.g. funeral expenses, home purchase, paying college tuition, etc.) that can apply as a triggering event.

What Happens to Your 401(k) If You Quit or Start a New Job?

You have several options for what to do with your 401(k) account when you quit or start a new job. This helps reduce some of the risk for individuals who “job hop” or work themselves up the career ladder. As low income families who have 401K plans will almost always be trying to improve their employment situation/income, and 401Ks are flexible to that. When changing or quitting a job, you can:

• Cash out your 401(k). You can opt to take the lump-sum distribution, but you will have to pay the 10% early withdrawal penalty as well as income taxes if it is a traditional 401(k) account.
• Leave your money in your old plan. You won’t be able to make contributions to the account anymore, and you’ll need to keep track of multiple accounts when you start a new job. Leaving your money in your old plan is not recommended as a long-term solution.
• Transfer your money to your new job’s 401(k) plan. Although not all plans allow it, you could potentially roll over your old balance to your new employer’s plan without penalty. Speak to your new employer on how to handle the transfer.
• Rollover your contributions to an IRA. Use the trustee-to-trustee transfer option to roll over your balance into an individual retirement account (IRA) without penalty. To avoid any penalties, don’t let the plan administrator write a check for the balance directly to you. Instead, have them write a check directly to the firm handling your IRA. Let the financial institution that is managing your IRA handle the details.

If you’re planning to quit your job, it is crucial to time your exit correctly to get the most out of your 401(k). If your employer offers matching contributions, then find out when those contributions are deposited. For example, if deposits are made once a year, then don’t leave before that year’s contribution is made. Also, check your employer’s vesting schedule to see if working a little longer will enable you to vest more matching contributions.

The Bottom Line

401(k)s are a great way to kick-start your retirement savings. There are low-up front costs, and even people with little income or savings can start. No employee, even if you are low income or say a single mother, should pass up the option to contribute to their employer’s 401(k) plan, especially if their employer agrees to match their contributions.

Contributions have annual limits that are set by the IRS based on inflation. However, those limits are high enough that you can potentially save hundreds of thousands of dollars by retirement age if you start contributing early. A 401(k) plan is a good example of compound interest in action; the sooner you start contributing, the better off you’ll be in your golden years.

Don’t be afraid to take investment risks, especially if you’re young. The available investment options can vary wildly, so consult a financial adviser to help you figure out the best strategy for you based on your age, goals, and risk tolerance.

By Jon McNamara