What is a 401K?
A 401(k) is a retirement plan that an individual sets up with their employer. If you are considering starting a 401(k), remember that it is never too late or too early to start planning for retirement.
The way that these are funded is by setting a specific amount to be taken from your paycheck each month and placed into your 401(k), pre-tax. Some employers may offer an employer contribution that is pre-determined (e.g. 3% yearly match); this is often times referred to as “free money”, but of course you’ll need to be vested in the company before these funds are yours to keep.
There are a handful of limitations to 401(k)’s that you should keep in mind:
- Until the age of 49, maximum yearly contribution to a 401(k) is $18,500. Individuals age 50 and older may be eligible to an additional $6,000 as a “catch-up contribution”.
- Employee contributions cannot exceed $36,500 per year.
- There are penalty’s for withdrawing from a 401(k) too early (more on this later).
- Employer contribution may not be accessible until the employee is vested within the company.
401(k)’s may invest your money throughout a handful of mutual funds made up of stocks, bonds, and money market investments. Additionally, some 401(k)’s are placed into target-date funds in order to be more conservative closer to the individual’s retirement date. Your personal 401(k) may be invested differently. Because 401(k) funding is pre-tax, actual income may be placed into a different tax bracket depending on your contribution and income level. This is simply another point of interest that should be considered when arranging a 401(k).
During the growth period of your retirement funds, it can be quite tempting to dip into your 401(k) in order to pay some bills or buy something new; this is typically a bad idea unless absolutely necessary. Withdrawing funds from a 401(k) prior to age 59 and a half will lead to a 10% early distribution penalty tax on top of the income tax that you’ll need to pay on that money. There are a handful of rules to avoid this 10% tax, but you will still be held responsible for income taxes and this also means that you’re dipping into your retirement income. Consider that you will not be working in retirement, so every penny counts when planning for the future!