When you first start a new job, you’ll probably be told about the company’s 401(k) plan during employee orientation. A 401(k) offers a great tax-advantaged opportunity for you to get started saving for your future.
Here’s what you need to know before starting a 401(k)
Chances are you’ve heard of a 401(k), but you may still have questions about this retirement plan. In this article, we’ll take a look at the basics of a 401(k) plan, annual limits, the all-important employer match and more.
Table of contents
- How a 401(k) works
- Annual limits
- Employer match
- Investment choices
- Why you shouldn’t borrow against or cash out your 401(k)
- Required minimum distributions
How a 401(k) works
A 401(k) is one of the most common types of retirement savings plans offered in the workplace. It’s set up by your employer and usually administered on their behalf by a big investment house like Vanguard or Fidelity.
401(k)s offer tax advantages for you and are widely touted as an employee benefit, along with any company match. More on that in a moment.
There are three key things to know about the way a 401(k) works:
- You contribute a percent of your salary before taxes, which lowers your taxable income in the present.
- The money comes out of your paycheck before you ever see it and goes directly into your 401(k) account.
- You don’t pay taxes on the money you save — until your withdraw it down the road in retirement.
So you’re lowering your taxes today by contributing to a 401(k) and building up a nest egg. But that nest egg gets taxed in the future.
(Editor’s note: Money expert Clark Howard believes today’s low tax rates are only going higher from here. That’s why he likes the Roth 401(k), which allows you to contribute post-tax money that’s never taxed again. Read his complete thoughts here.)
In 2019, the maximum you can contribute to your 401(k) is $19,000 per year. However, if you’re over 50, you’re allowed to make “catch up” contributions of an additional $6,000. That brings the total that people over 50 can contribute to $25,000.
As a general rule, Clark advises people to bump up their contribution rate by 1% every six months. If you keep doing this year after year, you’ll eventually reach the annual max.
So many employers have done away with private pensions and shifted the burden of saving for retirement to workers. That’s why many companies also offer some kind of employer match on your 401(k).
For every dollar you contribute, they’ll generally put in either 50 cents or a dollar, up to a certain contribution level. Check with your HR department for the specifics of your plan.
Let’s take a look at a simple example. Say you’re making $30,000 and you put 6% of your annual salary into your 401(k), which is $1,800. If your company matches with another 3%, that’s a free $900 you get to stash away — totaling $2,700 a year.
That means you’re really saving an effective 9% of your salary — definitely a good start!
“No matter how little or how much your company offers a match on, you’ve got to find a way to get it done,” Clark says. “Otherwise you’re leaving free money on the table.”
When it comes to picking investments to put into your 401(k), a lot of people freeze up and don’t know where to get started. But it can be surprisingly easy if you just invest your money in one of Clark Howard’s favorite options: Target date funds.
All target date funds are identified with a specific year (2040, 2045, 2050, etc.) in their name. You simply pick the year closest to when you expect to retire and put your money into that fund.
That invests your money in a simple portfolio that’s typically made up of stocks and bonds in a specific ratio that changes as you age.
“[Target date funds are] the ultimate in ‘set it and forget it’ investing and could be the best and easiest investment choice you ever make,” Clark says.
We’ve got a deeper dive on this simple investment in our target date fund guide.
Why you shouldn’t borrow against or cash out your 401(k)
One surefire way to sabotage the hard work you’re doing saving for retirement is to borrow against your 401(k). Or cash it out entirely when you change jobs.
There are several reasons why this is a bad idea. First, you’re likely to reduce or stop your contributions if you borrow against your 401(k) and are trying to pay it back. Second, your money misses out on future growth opportunities if it’s not in the stock market.
“When people do borrow from a 401(k), historically it means that they end up with not near enough money to live on in retirement,” Clark says.
401(k) penalties for early withdrawal
Even worse is just taking the money and running when you change jobs. If you do choose to cash out your 401(k) before you reach 59 1/2, you’ll typically get hit with taxes and penalties that can eat up some 40% of your money.
According to Fidelity, the taxes and penalties you’ll face include:
- Standard 10% penalty for early withdrawal*
- State income tax
- Federal tax, based on your marginal income tax rate
* Waived if you’re 55 or older in the year during which you leave your employer
For example, if you take a 401(k) with $10,000 in it and cash it out, you get a tax bill for roughly 20% upfront. Then when you file your tax return the following year, you get hit with another roughly 20% in taxes and penalties.
That means your $10,000 becomes more like $6,000 and you have zero saved for retirement.
Some smarter alternatives include the following:
- Leave the balance with your old employer’s plan if it’s being handled by a low-cost 401(k) provider like Vanguard or Fidelity. Under the law, you’re allowed to leave your account if it’s at least $5,000 in value.
- Roll the balance over to your new employer’s plan by doing a trustee-to-trustee transfer.
We’ve got more info about both options here.
Required minimum distributions
What about when you’re in retirement and it’s time to pull money out of your 401(k)?
Under IRS rules, you can begin withdrawing money from your 401(k) at age 59 1/2, if you wish. But by 70 1/2, you absolutely have to take money out each year — thanks to what are called required minimum distribution (RMD) rules.
If you don’t take your RMD annually once you reach 70 1/2, you face a tax penalty — regardless of whether you need the money or not.
The amount you have to take out as an RMD is determined by an IRS formula. But the basic idea here is the government considers how much money you have in your account. Then they divide that by the number of years that actuarial tables say you have left to live.
Meanwhile, the penalty for not taking out your RMD each after you reach 70 1/2 is hefty: You could end up losing a whopping 50% of the amount you should have withdrawn.
We’ve got a deeper explanation of how RMDs work along with some examples here.
A 401(k) is a great tool to help you save for your future. With so many people having access to a 401(k) at work, this can be the easiest entry point to kick-starting your retirement savings.
If you need to understand more about basic blocking and tackling when it comes to investing, be sure to read our guide to how to start investing and saving for retirement.
Meanwhile, if you have additional investing questions, you may want to consider calling our Consumer Action Center.
Contact Clark’s Consumer Action Center — a FREE help line open Monday-Thursday from 10 a.m. – 7 p.m and Friday from 10 a.m. – 4 p.m. EST. We have volunteers available to answer YOUR concerns! Call Team Clark @ 404-892-8227.