401(k) Benefits: Your Complete Guide to Growing Retirement Wealth

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A 401(k) might be your most powerful investment tool. There are several 401(k) benefits that offer advantages over other investing accounts, including tax savings, automatic investments and a potential for matching funds from your employer.

While many jobs offer 401(k) accounts, millions of Americans aren’t taking advantage of these accounts. This guide will cover how a 401(k) account works, the benefits of a 401(k) account, some pros and cons to consider and how to maximize your 401(k) to build wealth.

What Is a 401(k)? A Quick Overview

A 401(k) is an employer-sponsored retirement savings plan that can be offered through your job. You can invest money in your 401(k) plan directly from your paycheck, and your investments grow tax-free until retirement.

There are two types of 401(k) plans: the traditional 401(k) and the Roth 401(k).

Traditional 401(k)

Traditional 401(k) plans lower your taxable income in the year you contribute, which can improve your tax refund this year.

Roth 401(k)

Roth 401(k) plans don’t lower your taxable income when you contribute, but you can withdraw funds tax-free in retirement.

Most 401(k) plans are administered by a third-party custodian that partners with employers to offer investments. You can usually choose between a selection of mutual funds and ETFs, allowing you to create a diversified investment portfolio.

When Can You Withdraw from a 401(k)?

You can begin withdrawing from your 401(k) plan when you turn age 59 ½, but there are special provisions that allow some retirees to withdraw earlier — if you retire from the company that holds your 401(k) when you turn age 55.

Why You Should Consider a 401(k)

Investing in a 401(k) account comes with a few huge benefits that can boost your retirement savings while saving on taxes at the same time. Here are a few reasons to consider using your 401(k) account to build wealth:

Unbeatable 401(k) Tax Benefits

Investing in a 401(k) comes with multiple tax benefits.

• Pretax contributions — Traditional 401(k): Lower current taxable income
• Tax-deferred growth: Investments grow without annual taxes.
• Tax-free withdrawals — Roth 401(k): After-tax contributions lead to tax-free withdrawals in retirement.

Employer Matching Contributions: Free Money for Your Future

Many companies offer a “401(k) Match” program that helps you earn additional funds. When you contribute to your 401(k) account, your employer may match the funds you put in up to a certain percentage of your salary — or a set annual cap.

401(k) Matching Example

Your company 401(k) plan may offer a match up to 5% of your salary. This means if you earn $60,000 per year and invest $3,000, your company would put in an additional $3,000 in “matching funds.”

This is perhaps one of the best 401(k) benefits available. However, most matching programs require vesting, which is unlocks funds after a set amount of time. If you leave your job before your 401(k) is fully vested, you might lose some of your matching funds.

A Typical Vesting Schedule

Vesting schedules are typically set up to unlock your 401(k) matching funds after working at your job for up to four years.

A typically graded vesting schedule may look like this:

• After one year: Unlock 25% of matching funds
• After two years: Unlock 50% of matching funds
• After three years: Unlock 75% of matching funds
• After four years: Unlock 100% of matching funds

High Contribution Limits: Specify Annual and Catch-up Limits

401(k) accounts have the highest contribution limits of any retirement account, making them an excellent way to build wealth.

• Annual contribution limit: Employees can contribute up to $23,500 per year to the account, not even including the employer match.
• Catch-up contributions: If you’re age 50 or older, you can add an extra $7,500 in catch-up contributions.
• Special limits for those ages 60 to 63: For those aged 60, 61, 62 and 63, the contribution limit is bumped up to $11,250.
• Employer contributions: Your employer can contribute up to an additional $46,500, for a total of $70,000 in total annual contributions allowed, plus catch-up amounts.

Effortless Wealth Building Through Automatic Savings

When you contribute to your 401(k) account, it comes straight out of your paycheck. This makes it one of the easiest ways to invest, and automates the process of saving and investing for retirement. You never see the money hit your account, and you don’t have to make any transfers to the account yourself.

401(k) Pros and Cons

How To Get the Most from Your 401(k)

Here are a few things to keep in mind if you want to create a fine nest egg with your 401(k).

Invest Early

To maximize your 401(k) benefits, you should invest early and often. That’s because the money you deposit benefits from “compound growth.” The more money in your 401(k), the faster you’ll make money from investment growth.

Contribute the Maximum

If you can swing it, you should contribute the maximum annual amount to your 401(k). That means up to $23,500 per year. For those between the ages of 50 and 59, you can deposit an extra $7,500 in catch-up contributions. For those between the ages of 60 and 63, you can deposit $11,250 in catch-up contributions.

Deposit as Much as the Employer Match

At the very least, strive to deposit as much as your employer is willing to match. This is free money and the best return on investment you can get in your retirement account.

Also, note that you can usually choose how your 401(k) is invested to a degree — your employer typically gives you options. Make sure you diversify your investments to safeguard against a downturn in the market.

401(k) Loans and Hardship Withdrawals: What You Should Know

If you’re in a situation where you need cash, you may be tempted to draw from your 401(k). While this is typically not a good idea — you don’t want to undermine your retirement trajectory — it can make sense in some cases, such as to pay off high-interest debt.

401(k) loans are a popular option, allowing you to spend your money without penalty. The catch is that you must pay back your loan, often within five years. You’ll pay “interest,” but that money will also deposit into your 401(k).

Alternatively, you can apply for a hardship withdrawal, which you don’t have to pay back, and avoid penalties under certain circumstances. For example, if you have medical or funeral expenses, or if you’re facing eviction, you may qualify for a hardship withdrawal.

Here’s what to keep in mind when deciding whether to access funds from your 401(k) before retirement:

• Traditional withdrawals are subject to a 10% penalty when you withdraw younger than age 59½.
• Your taxable income will increase in the year you choose to withdraw.
• You’re reducing your retirement savings — and therefore your annual compounding growth — when you withdraw.
• If you leave your job before repaying a 401(k) loan, you may be required to pay it off faster.

401(k) vs. Other Retirement Accounts: A Brief Comparison

A 401(k) is far from your only option when it comes to preparing for retirement.

IRA

Another popular choice is an Individual Retirement Account. It’s like a 401(k) in that you won’t pay taxes on your contributions until you withdraw them, as well as a 10% penalty — in most cases — when withdrawing before age 59 ½.

An IRA plan is not employer-sponsored. You’ll open the account with a broker instead of through your company.

IRAs also have a considerably lower annual contribution limit:

• $7,000 for those under 50
• $8,000 for those 50 and over

Roth IRA

You may also consider a Roth IRA, which is similar to a traditional IRA, in that you’ll open it through your personal financial institution, not through your job. In other words, you won’t get any employer contribution matches.

With a Roth IRA, you’ll pay taxes on the money first, then deposit it into your account. This means you won’t owe taxes on the money you’ve contributed when you withdraw, though you’ll still pay a 10% penalty when withdrawing before 59 ½.

An advantage for IRAs is that you get to choose your investments, with thousands of choices through your broker vs. the limited 401(k) investment options. This can help you build a more diverse portfolio with lower fees.

The best IRA for you depends on whether you think you’ll be in a higher or lower tax bracket after you retire. If you think you’ll be in a lower tax bracket than you are now, it may be wise to stick with a traditional IRA so you’ll pay less taxes later.

Final Thoughts: Is a 401(k) Right for You?

With little exception, you should take advantage of any 401(k) benefits your employer offers. The deferred taxes can make it easier to save now, and employer contribution matches can literally be a life changer. Its high annual contribution limits are exponentially greater than some other retirement accounts.

Still, it’s worth examining other retirement plans to find the best plan for your unique financial situation. If you’re not sure which account to invest in for retirement, it can be a good idea to meet with a licensed financial advisor to review your options to find one that’s a good fit for you.

Joseph Hostetler contributed to the reporting for this article.

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