A 401k is a type of investment account designed to help you save for your retirement. The money you put into a 401k isn't taxed by the federal government, and you can invest it in stocks and bonds to build a nest egg that will potentially provide you with an income even after you've concluded your career.
A 401k is a tax-advantaged account that helps people save for retirement. The government wants to encourage you to save for retirement, so it offers a chance to put your money into an investment account without having to pay any taxes on it. The name “401k” is a reference to the section of the IRS code that outlines the accounts and how they function.
The ability to invest untaxed income directly means that you can save significantly more of your money than you would actually receive in your paycheck. What’s more, many employers offer to match your 401k contribution up to a set portion of your income (usually 3 to 5 percent), meaning that your 401k contributions are essentially doubling in value once you make them.
This is why there’s probably no better advice for saving for retirement than setting up an automatic payroll deduction for your 401k that, at the very least, takes full advantage of whatever your employer is ready to match.
Say you’re earning $55,322 a year (the median salary in the United States) at a job where your employer matches 401k contributions up to 5 percent. Your take-home pay for a semi-monthly paycheck is likely going to be around $1,780. However, if you decide to make that automatic 5 percent 401k contribution, you’ll be kicking $115 of each check into your 401k but only giving up $87 in after-tax pay. After your employer’s matching contribution, your $87 is turning into $230 twice a month.
And all of that is before considering how compound interest multiplies those results over time. Over the course of 30 years, even if you never received a raise or bonus, assuming a 7 percent rate of return compounding annually, your $87 per paycheck will grow into a 401k account worth over a quarter million dollars. For comparison, that $87 every two weeks for three decades would only add up to a little over $60,000 without the tax advantages, employer matching funds and compounding interest.
There are a few different types of 401k plans, so it’s worth understanding which ones are available to you. All 401k plans must follow the rules laid out by the IRS, which include annual limits on how much you can contribute and rules about when you can withdraw money without penalty.
Traditional 401k plans
Your 401k plans include certain limitations to ensure that they’re used primarily by people saving for retirement and not by the super rich to dodge taxes. As of 2018, annual deferments to a 401k are limited to $18,500 a year with the option to make an additional “catch-up” contribution of up to $6,000 a year after the age of 50. Likewise, you will have to pay a steep penalty to pull money out of your 401k before you turn 59 and a half, though there are exemptions for certain special situations.
Safe Harbor 401k Plans
Traditional 401k plans are subject to annual “non-discrimination testing,” which ensures that a 401k plan is appropriately benefiting all employees and not just high-level or upper-management workers. There are alternative safe harbor 401k plans, though, that allow an employer to avoid the potentially expensive testing process.
In a traditional plan, employers can include conditions where their contributions don’t fully vest for a few years as a way to retain employees. Safe harbor plans offer a simple trade-off: employers can avoid the hassle and expense of annual testing on their 401k plan, but they have to offer contributions that are fully vested at the time they’re made and notify employees about the nature of the 401k plan each year.
SIMPLE 401k Plans
The SIMPLE 401k plan was created to offer small businesses options for 401k plans that are simpler to administrate and avoid the complex nondiscrimination testing. SIMPLE 401k plans don’t have annual testing, require annual notices to employees, must have fully-vested employer contributions and are only available to employers with 100 or fewer employees.
Additionally, the contribution limits for SIMPLE 401k plans are lower: $12,500 a year with only $3,000 a year in catch up contributions after 50.
Designated Roth Account
A designated Roth account is a separate account within your 401k that allows for Roth contributions. Roth retirement accounts have after-tax contributions, but as long as you follow the rules, you don’t pay any tax on money when you withdraw it later. So, you don’t get the advantage of avoiding taxes on your contributions, but you do get to avoid paying any taxes on the investment income they produce.
Your employer can set up a designated Roth account within a 401k plan that is very similar to a Roth IRA independent of an employer. However, one major difference for a designated Roth account is that the caps can be much higher. Annual contributions for a traditional Roth IRA are capped at $5,500 until the age of 50, and then $6,500 a year after that, but designated Roth accounts fall under the normal rules for 401k contribution limits. That means that the combined contributions to your normal, pre-tax 401k and your designated Roth accounts combined can be up to $18,500, allowing you to exceed that $5,500 limit by quite a bit if you structure your contributions accordingly.
One major benefit of many 401k plans is the option for automatic deductions from your paycheck. With the wide range of potential expenses in our daily lives, it can be easy to overlook saving for yourself. By setting up an automatic contribution, your savings will continue to grow with each paycheck without requiring any action on your part.
Particularly when your employer offers matching funds, setting an automatic contribution can be an essential way to ensure that nothing disrupts your efforts at building an all-important nest egg to provide for your future.