Maybe you’ve been thinking about getting started investing for retirement, and now’s the time. Or maybe you just started your first job, and you’re wading through your new employer’s 401(k) information. Or maybe you’re already contributing to a 401(k), but you aren’t 100% sure how the account actually works.
No matter where you are in your 401(k) journey, a refresher on the basics never hurts. Here are 10 fast facts about 401(k)s.
1. A 401(k) is tied to your job
The only way you can use a typical 401(k) is if your employer offers it. (There are some special account types for entrepreneurs and small business owners, though.) That’s not the case with an Individual Retirement Account (IRA), which is available to anyone with income. Here’s the lowdown on the difference between the two.
If you decide to take advantage of your employer’s 401(k) plan, they’ll help you set it up so that your contributions — usually a percentage of your salary — come out of your paycheck automatically.
Many employers also offer a 401(k) employer match. That means if you put money into your account, they’ll put some in, too. This is actual free money, so it’s in your best interest to contribute enough so that you’re getting the full amount of the match. Here’s what you need to know about 401(k) employer matches.
2. There are two main types: traditional and Roth
Half of US employers offer Roth 401(k)s in addition to “traditional” 401(k)s. The difference between them is when you pay taxes: With a Roth account, you pay taxes now, and then you’ll be able to withdraw the money during retirement tax-free. With a traditional account, you don’t pay taxes now (contributions are made “pre-tax”). Instead, you’ll pay them when you make your withdrawals.
You can have one or the other, or both. It’s up to you. Here’s an explainer on the difference between the two and how to decide between them.
3. The contribution limit for 2020 is $19,500
The IRS says you can’t contribute more than the limit to your 401(k) in any given year. In 2020, it’s $19,500 ($26,000 if you’re 50 or older). Btw, that’s a lot more than you can contribute to an IRA ($6,000 or $7,000 if you’re 50+).
If you’re just starting out, that limit might seem mythically high. But you can work your way up to it. Once you’re more financially stable and can start putting extra toward retirement, it’s worth checking to see if your 401(k) will be enough.
4. There’s no income limit to participate
There’s no such thing as “making too much” to contribute to a 401(k) — traditional or Roth. Although if you’re considered a “highly compensated employee” (as in, you make more than $125,000 per year, are in the top 20% of earners in the firm, or own more than 5% of the company), your contributions might get capped. Check with your HR team or 401(k) plan administrator if you think that might be you.
5. You can take out loans against your 401(k)
Yes, some plans let you borrow from your 401(k). These are creatively called “401(k) loans,” and you usually pay them back through extra payroll deductions. Our advice: Be very careful in deciding whether to take a 401(k) loan. If you leave your job, you’ll owe the full remaining balance by the day that year’s tax return is due — and if you can’t pay it back by then (and you’re younger than 59½, see fact #6), you’ll owe a 10% early withdrawal penalty plus any income taxes.
Also, if you take the money out, it won’t be able to benefit from any potential market gains (which is why you put it in there in the first place).
6. You can’t make withdrawals until you turn 59½
Because a 401(k) has tax advantages, the IRS doesn’t let you just withdraw from it whenever you want. You have to wait until you’re “retirement age” — which is, according to the IRS, 59½. If you try to withdraw early, the money you take gets taxed and hit with that 10% penalty fee. (Yikes.)
There are some exceptions to this rule. For example, if your 401(k) is with the employer you’re retiring from, you can withdraw starting at age 55. You might also be able to use your 401(k) for specific hardships like disability or significant medical expenses.
7. You have to start taking money out when you turn 72
The money in your 401(k) grows tax-free, so the IRS isn’t going to let you leave it in that account forever. You have to start taking required minimum distributions (RMDs) in the year you turn 72 (unless you’re still working). This is true for both Roth and traditional 401(k)s (which is different from Roth IRAs, which don’t have RMDs).
8. You’ll have to pay fees
Yep. There are two main types of fees that come with retirement accounts. The first is 401(k) fees, which go to the company that sets up and manages your plan for you. The second is fund fees (sometimes called “expense ratios”), which pay the companies that run the investments you hold in your investment portfolio.
Generous employers might pay some of those fees for you, but you’re likely going to at least pay the fund fees. They’d come out of your account automatically, so it’s easy to forget they’re even there. But fees can cost you a ton of money over the life of your account. Here’s more information about investment fees and how to figure out what you’re paying.
9. You can often choose your investments
Most 401(k) plans will present you with a limited set of investment options to choose from. A lot of the time, these are things like “target date funds,” which are collections of investments designed to fit your needs based on the year you expect to retire. This is one place where you might be able to control your fees.
10. You can’t keep putting money in if you leave your job
If you get a new gig, you won’t be able to contribute to that old company’s 401(k) anymore. In that case, you might want to roll it over into an IRA or (if possible) your new employer’s 401(k). Here’s more info on 401(k) rollovers, and here’s our advice on rolling money over smoothly.
Those are the ten big things to know about 401(k) plans. And just like that, you’re one step closer to the future that Future You is dreaming of.