What Exactly Is a 401(k) and How Does It Work?

What a 401(k) Is#

A 401(k) is an employer-sponsored retirement plan. It allows employees to contribute a portion of their income to the plan without having to pay taxes on it right away.

Taxes Are Deferred, Not Eliminated#

Money put into a 401(k) is not taxed when it goes into the plan. Instead, taxes are deferred until the money is withdrawn from the account later on.

Vesting Schedules Decide How Much of the Money Is Yours#

Vesting determines how much of the money contributed to a 401(k) an employee actually owns over time. Since 401(k) vesting schedules were reduced in 2002, the longest allowed schedules are shorter than they used to be.

Borrowing From Your 401(k)#

Some 401(k) plans allow employees to borrow against their own account balance. A 401(k) loan comes with set limits on how much can be borrowed and what interest rate applies.

Why a 401(k) Loan Should Be a Last Resort

Borrowing from a 401(k) plan should only be considered as a last resort. Although it is convenient, a 401(k) loan comes with several disadvantages:

• If you lose or change jobs before the loan is repaid, the outstanding amount would have to be repaid either before the last day on the job, or within a specified period, generally 90 days. If it is not repaid, the amount owed becomes taxable and the IRS will add an additional 10% penalty for early withdrawal of the money if you are under the age of 59.5.
• You are replacing pretax money with after-tax money. For example, if you are in the 27% tax bracket, it will take about $1.40 in salary to replace every $1 you borrowed from your account.
• Instead of letting the money grow on its own by earning interest on your investments, when you pay back the loan you are paying the interest out of your own pocket.

A 401(k) loan may be an attractive option for some people, but it is important to be aware of the potential pitfalls. As with any other loan, do your homework and ask questions before signing on the dotted line.

Hardship Withdrawals When Loans Aren’t Allowed#

When a 401(k) plan does not permit loans, the law generally allows a hardship withdrawal if the employee is unable to borrow money from any other source. Qualifying reasons include:

• A down payment on a primary residence
• College tuition for the employee or dependents
• Certain unreimbursed medical expenses
• Preventing foreclosure on or eviction from the home

What Happens to Your 401(k) When You Leave a Job#

An employee who leaves an employer with a 401(k) account balance of more than 5,000 dollars can leave the money in the plan or transfer the vested balance to a new employer’s qualified plan or a rollover IRA. This usually must be done within 60 days.

If you don’t reinvest the money within 60 days, your account will be treated as an early withdrawal, which means you will be subject to regular income tax, plus a 10% early withdrawal penalty, providing you are under age 59.5.

Why Start Saving for Retirement as Early as Possible#

Compound interest is more beneficial to you if your investment is allowed to compound for a longer period of time: the more years your money has to compound, the more money you’ll end up with when it’s time to retire. That does not mean devoting the majority of your paycheck to your retirement account right off the bat. Start by saving a little bit out of each paycheck and gradually work your way to saving more each year. Anything you can contribute is worth contributing.

Consequences of Not Saving#

Being ill-prepared for retirement can put you in a very uncomfortable position. If your retirement account isn’t enough to provide you with food, shelter, and the other daily necessities, you’re at risk of depending on your children to provide you with somewhere to live, or of depending on welfare. Medical needs matter too: a completely healthy person in retirement would require less money to live off of than someone who develops osteoporosis or arthritis later in life.

It’s Not Too Late to Start Saving for Retirement#

• Fund your 401(k): if your current employer offers a 401(k) plan, enroll as soon as possible. The earlier you start contributing, the more time your funds will have to grow, and if your employer matches your contributions, you will be able to take advantage of that.
• Put yourself first: don’t spend extravagantly on other family members if you feel that money would better be put away for retirement.
• Save independently: it’s also a smart idea to save money outside of your 401(k) as a safety net. Deposit what you can, when you can, and set small goals each month for what you can avoid spending money on so you can save it instead.

How Will You Live in Your Golden Years?#

When you reach your forties, you should begin considering the lifestyle you’d like to have in your golden years and what kind of income you’ll need to live comfortably. Keep in mind that retirees are living longer than ever before, so you may need more money than you think.

This is also the time to start planning for quality of life issues. After retirement, any medical insurance you carry will be paid only by you, not your employer, and medical insurance premiums rise significantly with age. Medical concerns are potentially the most expensive aspects of retirement planning. Long-Term Care Insurance, which helps pay for nursing home care, is an idea worth considering; consult an insurance professional for help finding the best plan for you.

In your forties, it is also time to start reallocating your retirement funds into investments that will give you more income than growth, while still keeping a significant growth component in your portfolio. It is highly recommended that you consult a financial advisor to help you allocate your funds in a manner that is appropriate to your situation.

In Your 30s#

By the time you’ve reached your thirties, the first and most important step to retirement planning is to establish a budget that allows you not only to handle your expenses, but also to save money. It is not difficult to set up a workable budget, but it can be a challenge to stick to it. Keep away from wasteful spending and put your effort into creating a financial cushion for yourself; without a cushion, it is almost impossible to save for retirement.

Once you have been able to establish a budget and save some money, the next step is to increase the amount of money you contribute to your retirement accounts, particularly to your 401(k) plan. It is generally recommended that you start contributing at least ten percent of your income, more if possible.

If your financial situation is more stable than it was in your twenties, it is often advised that you think about buying a home. Over time, houses tend to increase in value, but home prices do not always go up: real estate is subject to market forces like any other investment. If you buy your home with a mortgage, you will build equity in the home, which is the value of the home minus your mortgage balance, and as you pay the mortgage down, your equity increases. Homeowners also often get better insurance rates, since many insurance companies offer package deals that combine auto and homeowner’s insurance.

In Your 20s#

For most people in their twenties, retirement is a long way off, but that does not mean you should put off your planning. The steps you take to establish yourself in your twenties can have a significant impact on the quality of your retirement.

• Establish a budget: by putting together a workable budget, you will be in a better position to handle unexpected expenses. Keeping track of your spending will help you keep on top of your day-to-day finances, and give you a clear picture of what you can and cannot spend.
• Establish good credit: paying your bills on time and keeping your debt level under control will serve you well throughout your entire life, including in retirement. By handling credit wisely, you will have more money to save for retirement.
• Contribute to a 401(k) plan, IRA, or other tax-deferred account: being in your twenties gives you a tremendous financial advantage: time. Investments grow through compound interest, which is when new interest is earned on top of interest you’ve already accumulated.

When you’re young, it is recommended that most of your money is invested aggressively, because your goal at this stage is to make your money grow. As you age and get closer to retirement, your goal will change to preserving your gains, and it is recommended that you shift your investments to less aggressive plans. It is always a good idea to consult an investment professional to help plan the best strategy for your situation.

What to Do Next#

If you are changing jobs or thinking about borrowing from your 401(k), it helps to review your plan’s vesting schedule and rules before making a decision. We provide consumer education to help people understand how retirement accounts fit into their overall financial picture.