The 401(k) is the most popular type of retirement plan offered by private-sector employers to help their employees save and invest for retirement. Unlike traditional pension plans, 401(k)s are known as defined contribution plans, and the retirement benefits they produce depend on the performance of the account’s underlying investments.
401(k) retirement plans may seem complicated, but they don’t need to be. Here’s an in-depth discussion of what a 401(k) is, why you should contribute to one if you can, how investing in a 401(k) works, the tax benefits of 401(k) investing, and more.
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What is a 401(k)?
A 401(k) is a form of defined-contribution retirement plan, as opposed to a defined-benefit plan like a pension.
Instead of contributing money throughout your career to receive a fixed amount of income when you retire, a defined-contribution plan involves contributing a set percentage of your compensation. Instead of fixed retirement income, your nest egg depends on how well the investments held in your account perform.
401(k) plans are offered by employers to allow their employees to set aside money for retirement on a tax-advantaged basis.
Employers may make contributions to 401(k) plans on their employees’ behalf, and money in a 401(k) plan can be invested in a selection of mutual funds or other investment options (like company stock) offered by the specific plan.
Reasons to use a 401(k) to save for retirement
The main reason to use a 401(k) to save for retirement as opposed to simply investing in a standard brokerage account is for the tax benefits. Most 401(k) contributions are made on a tax-deferred basis, meaning that the money you choose to contribute, up to the annual contribution limit, is excluded from your taxable income. After it is contributed, your investments can grow and compound year after year with no tax implications until you withdraw money, at which time the amount of your withdrawal will be considered taxable income.
401(k)s are increasingly offering Roth contribution options. This means that the contributions are not tax-deductible, but your investments still grow and compound tax-deferred and qualified withdrawals will be 100% tax-free. We’ll get into the differences between standard and Roth 401(k) contributions and which you should use later on.
Another good reason to use a 401(k) to save for retirement is that it’s easy. Once you’ve set your 401(k) investment allocations, the ongoing maintenance that is required is minimal. Contributions are automatically deducted from your paycheck and you can even choose investment options that will gradually shift your allocations over time as you get older.
Can you open a 401(k) on your own?
The short answer is “it depends.” To open a 401(k) account, you need to join a plan sponsored by an employer you work for.
However, that employer can be yourself. Self-employed individuals and independent contractors can open individual 401(k) accounts (also known as “solo” or “one-member” 401(k)s). The same contribution limits apply, and the employer matching portion can’t exceed 25% of self-employment earnings.
401(k) contribution limits
The 401(k) contribution limits are set by the IRS each year and are increased to keep pace with inflation as time goes on.
For 2018, the elective deferral limit is $18,500, meaning that you can choose to have as much as this amount withheld from your paychecks and deposited into your account. If you’re 50 or older, you can choose to defer as much as $6,000 more as a “catch-up” contribution for a total of $24,500.
Keep in mind that this includes only the money that you choose to contribute. It does not include employer matching contributions, forfeiture allocations (when someone else loses unvested contributions), mandatory contributions, or contributions from any other sources.
The overall limit from all sources for 2018 is $55,000, including your own elective deferrals. If you’re 50 or older, the catch-up contribution limit is added to this, for a grand total of $61,000.
What is 401(k) vesting?
The term “vesting” is used to describe your ownership in the assets contained in your 401(k) plan. Simply put, if you are vested, you have the legal right to keep the contributions made to your account.
To be clear, you are always 100% vested in contributions you make to your 401(k). However, the same is not always true when it comes to your employer’s matching contributions.
Employers can choose to immediately vest their contributions, or they can follow one of two vesting schedule types:
- Graded vesting means that your contributions vest a little more each year. At a minimum, employees must vest in 20% of their contributions at the end of the second year or service and another 20% each year thereafter. So, by the end of the sixth year of service, employees on a graded vesting schedule will be 100% vested in their entire 401(k) account.
- Cliff vesting means that there is a certain period of time where employees are not vested at all, and then become 100% vested at once. Employers who select cliff vesting can push the vesting date as far out as three years of service.
How does employer matching work?
The majority of 401(k) matching programs have the same general structure. The employer will match a certain percentage of employee contributions up to a certain percentage of their compensation. As an example, an employer may match its employees’ contributions dollar for dollar up to a maximum of 5% of their salary.
In this case, an employee who earns $50,000 per year would have all of their contributions up to $2,500 matched dollar for dollar by their employer. To be clear, they could certainly choose to contribute more than their employer is willing to match, but the amount of employer contributions will be limited according to this rule.
How much should you contribute to your 401(k)?
Financial planners have differing opinions on this. Most agree that at a minimum, participants should contribute as much as their employer is willing to match. So, in our previous example, this hypothetical employee should contribute 5% of their salary at an absolute minimum. Not contributing enough to take full advantage of your employer’s matching program is like refusing to take a portion of your salary.
As a general rule, I suggest a retirement savings rate of 10%, not including matching contributions. I’ll spare you the mathematics, but this percentage of the average worker’s salary compounded at historical average investment returns should grow into enough of a nest egg that should be able to produce enough income for a comfortable retirement.
However, you don’t necessarily have to put it all in your 401(k). For instance, it’s fine to set aside 5% of your salary in your 401(k) — as long as it’s enough to get your employer match — and another 5% in an IRA, which has some key advantages as well.
IRAs versus 401(k)s
On that note, let’s briefly discuss the differences between investing for retirement in individual retirement accounts, or IRAs, and employer-sponsored plans like 401(k)s.
As I mentioned, there are some key advantages to IRA investing. For starters, while your 401(k) offers a selection of a few dozen investment choices at most, you can buy virtually any stock, bond, or mutual fund you want…