The 401(k): Retirement Fund Basics

A 401(k) is one of your options to ensure you have a nest egg in preparation for your retirement. Most employers offer this company-sponsored retirement plan as part of your benefits package.

Signing up for a 401(k) means contributing a portion of your salary to this retirement account. You have complete control of how much your annual contribution will be. Most companies also offer to match your contributions to a specific limit, which increases your overall contribution. The maximum allowable employee-employer contribution for 2022 is $61,000 (or $67,500 for those 50 or older).

The contribution process is efficient since it’s automatically deducted from your payroll, saving you the trouble of making manual contributions throughout the year. Like other retirement plans, your funds are invested in your preferred channels, allowing them to grow (often tax-deferred) and earn interest over time.

An excellent way to prepare for retirement is to take advantage of the 401(k) most employers offer as part of your benefits package. Your company sets it up for you if you decide to sign up, which can save you a lot of administrative work.

There are several benefits to having a 401(k). For one, it offers a lot of flexibility. You can choose how much of your annual salary to contribute. For example, if your income amounts to $60,000 and you contribute 8%, that comes to $4,800. The amount is then divided per the number of paychecks you receive and automatically deducted, pre-tax, from your salary.

Most employers have a matching program, wherein they add a corresponding amount based on your contributions. Continuing the example above, if your company offers to match half of your contributions, your total combined contribution for the year becomes $7,200.

You also have the freedom to decide where to invest your savings. Most companies already have a portfolio of investments, so the only thing you need to do is choose. Your money grows in our account and typically won’t be taxed until you begin taking distributions.

Once you turn 59 ½, you can begin making withdrawals without penalty. Otherwise, you may have to pay a 10% additional tax.

Joining a 401(k) is an excellent way to prepare for retirement. As all retirement plans go, the earlier you begin, the better off you’ll be. However, 401(k) plans come in various types, and knowing how these plans compare can help you make better financial decisions.

Some 401(k) plans are better suited for some situations. MoneyGeek’s guide covers several and highlights when these are most beneficial so you can choose which best fits your needs and preferences.

A traditional 401(k) is a retirement plan most employers commonly offer that uses pre-tax dollars from your salary as a contribution. These are automatically taken out from your pay, making for an efficient contribution process. For 2022, you can contribute as much as $20,500. The limit increases to $27,000 if you’re 50 or older due to catch-up contributions.

Your company can also make contributions to your traditional 401(k), putting it directly into your account. The most significant advantage it offers is that your money grows tax-deferred, meaning you will only need to pay for taxes when you make a withdrawal or when you need to take the Required Minimum Distributions (RMD) after turning 72. Remember, even your employer’s contributions follow the same process. These remain tax-deferred until you withdraw them.

Traditional 401(k) plans can be an excellent option if you foresee yourself falling into a lower tax bracket when you start making withdrawals.

Like the traditional 401(k), a Roth 401(k) is also a sought-after plan type. These two have similar setups, where your contribution comes from your payroll and can be matched by your employer. However, if there is a matching program, their matches are deposited into a separate tax-deferred account, not directly to your Roth 401(k).

A Roth 401(k) uses after-tax dollars, so you don’t have to pay for taxes when you make qualified withdrawals in the future. All your earnings, whether from interest, capital gains or dividends, grow tax-free.

This 401(k) type is usually attractive to millennials or high earners. It also works best for individuals who see themselves in a higher tax bracket in their golden years.

You are also required to take RMDs once you turn 72. However, you can avoid it by rolling your Roth 401(k) to a Roth IRA, which doesn't require you to take minimum distributions.

Another 401(k) option is the safe harbor plan, which doesn't have to go through most annual compliance tests. It shares similarities to a traditional 401(k), especially regarding employee contributions. However, they have two differences that bring you significant benefits.

Although most employers also contribute to traditional 401(k) plans, these aren’t mandatory. They may even have conditions before beginning contributions, such as the employee working for 1,000 hours or meeting an age requirement. In comparison, safe harbor plans require employer contributions.

You'll automatically have 100% vesting immediately, meaning you own everything in your safe harbor 401(k) as soon as you open it. Employers using other 401(k) types may put a vesting schedule in place for traditional 401(k) plans, whether a 3-year cliff or a maximum of 6-year graded. It will look something like this:

Source: IRS — Vesting Schedules for Matching Contributions

If you decide to leave after four years of service and your employer uses a 6-year graded vesting schedule, you only own 60% of your 401(k). They can withhold the unvested amount, which isn’t possible with Safe Harbor plans.

Small business owners (those with less than 100 employees or less) may find a Savings Incentive Match Plan for Employees (SIMPLE) 401(k) a good fit. It shares features of both a traditional 401(k) and a SIMPLE IRA and offers benefits to employees in a cost-effective way.

Like safe harbor 401(k) plans, employers using a SIMPLE 401(k) are also required to make contributions, which are automatically vested. However, your annual contribution limits are lower.

Employees can contribute a maximum of $14,000 in 2022. For those 50 or older, you can have a catch-up contribution of $3,000. Employers also have to comply with contribution limits. Their options are as follows:

A dollar-for-dollar match for employees contributing up to 3% of their salary A 2% non-elective contribution for all eligible employees

Stipulations include that A SIMPLE 401(k) must be your sole retirement plan, and you would need to file a Form 5500 each year to maintain it.

A self-employed individual can also have a 401(k), but it falls under a different type. These are called solo or one-participant 401(k) plans. In essence, it’s a traditional 401(k) for a business owner who doesn’t have employees. You do not need to undergo nondiscrimination testing, which lessens your administrative work.

What makes a solo 401(k) different is that the business owner acts as both the employee and the employer, which means you can contribute from both roles. As an employee, your contribution limit for 2022 is the same as a traditional 401(k) — $20,500 if you’re under 50 and $27,000 if you’re over 50. You can contribute up to 25% of your compensation as an employer.

For example, Jane, 53, earned $90,000 from Company Z, which she owns. As an employee, she puts in $27,000 (including her catch-up contribution). As an employer, she contributes $15,000 to her 401(k).

If you’re self-employed, you can use the rate table or worksheets from chapter five of IRS Publication 560 to determine your contribution limit.

Knowing your 401(k) plan options allows for a better understanding of which one could work best for you. Once determined, the next step is to join one. Since 401(k) plans are employer-sponsored retirement plans, it’s easy to leave everything up to them. However, there are still several areas you should consider. MoneyGeek’s guide walks you through these areas.

Most employers offer a 401(k) as part of their benefits package, but it might not always be the case. A mountain of paperwork is typical when you join a new company. Sometimes, your 401(k) gets buried.

If you had a 401(k) with your previous employer, it pays to look at what your new company offers. You may find that you have more options and a different approach provides additional benefits.

Here are the steps to keep in mind if you want to join a 401(k).

Generally, it’s possible to join your employer's 401(k) on your first day. However, you may find yourself in a different situation.

Some organizations require a waiting period — it may run from a couple of months to as long as a year. It’s best to clarify this with your employer so you can join as soon as you qualify. That’s the best way to maximize your 401(k).

A waiting time shouldn’t stop you from saving for retirement. Except for a SIMPLE 401(k), most don’t restrict you to a single retirement plan. So while you can’t contribute to your company’s 401(k), you can consider opening an IRA.

In 401(k)-speak, vesting refers to ownership. Whatever amount you contribute to your plan is yours. However, your employer may apply a vesting schedule to their contributions.

Regardless of whether your employer applies a 3-year cliff or a graded vesting schedule, it means staying for a specific number of years of service before you can entirely own your employer’s contributions.

When you’re fully vested, it means 100% of what’s in your 401(k) is yours. It's ideal because no matter when you decide to leave, you can rightfully claim everything in your account.

Before deciding how much of your salary you want to contribute to your 401(k), check if your company has a matching program. Usually, employers match your contributions up to a certain percentage. Make this your minimum contribution if possible because it can amount to several thousands of dollars of additional savings per year.

For example, you earn $50,000 a year, and your employer matches your contribution up to 4%. The table below shows example calculations of how your combined contribution changes depending on your employer’s specific matching program.

Remember, you can contribute up to $20,500 in 2022 ($27,000 if you’re 50 or older). So you can increase your contribution if you still haven’t reached it.

There are different types of 401(k) plans, so it’s crucial to understand which ones your employer offers. Usually, your choices are between a traditional and a Roth 401(k). Depending on your preferences and what tax benefits you’re after, one might be a better option than the other.

If you belong to an organization with less than a hundred employees, a SIMPLE 401(k) might be available. Remember, if you go with this option, you cannot have another retirement plan, and the annual contribution limit is also lower.

Some employers might have a safe harbor 401(k) plan if they don’t want to undergo the annual testing requirements.

All types of 401(k) have their advantages and disadvantages. It’s best to understand these clearly to make an informed decision.

You're free to choose which investments you want to pursue from the selection your employer presents. These may include Target-Date Funds, Mutual Funds or Index Funds. The best option is different for everyone because you should consider several factors.

One is your risk tolerance level. No investment is risk-free, but your risk tolerance may make some a better fit than others.

The other thing to consider is the investment fees you need to pay. These vary depending on the investment option you choose. For example, mutual funds are an excellent option but may charge a higher fee since it's managed by a professional.

Investment fees are deducted directly from your investment returns, so if you’re not careful, you might get less than what you expected.

This step might not apply to you if this is your first 401(k). However, you might have a trail of old 401(k) accounts if you’ve been with several employers. Worse, you might have forgotten about some of them! Capitalize’s white paper shows that as of May 2021, there are around 24.3 million forgotten 401(k) accounts.

In most cases, employers allow you to keep your 401(k) plans where they are even after you’ve moved on to a different company, especially if it has more than $5,000. However, you can’t contribute to it anymore. Some people deliberately do this, especially if they're happy with their former employer's investment choices.

However, a better option is to roll your old 401(k) balances to your new plan. It frees you from the responsibility of having to manage a rollover IRA because your new plan’s administrator can take care of it. Best of all, all your funds are in one place, making monitoring (which is the last step) convenient.

Once you have your 401(k) set up, it doesn’t mean that the next time you look at it is when you’re preparing to make a withdrawal on your 60th birthday. It’s crucial to keep an eye on how your 401(k) is faring.

More than just monitoring the balance, you also need to check whether or not your investment options are working out for you. It’s best to talk to your plan administrator about your options. You aren’t locked in, even if you’re currently investing in target-date funds, so changing your mind is always possible.

Market conditions may also change and require you to prioritize some investments over others. You don’t have to be hands-on with your 401(k), but being completely hands-off isn’t ideal either.

The contribution limits in 2022 are slightly higher than those in 2021. Employees with traditional, Roth and safe harbor 401(k) plans can contribute up to $20,500, or $27,000 if they’re 50 or older.

SIMPLE 401(k) plans have a lower limit of $14,000 and a catch-up contribution limit of $3,000.

However, employees aren’t the only ones contributing to their 401(k) accounts. For traditional 401(k) plans, an employer can choose to match their employee’s contribution up to a certain percentage.

Another option is to make a non-elective contribution, which means contributing an amount equivalent to a specific percentage of each qualified employee’s salary. If you go in this direction, it applies regardless of whether or not your employee decides to make a salary deferral. You can change your non-elective contribution each year.

Employers’ contributions are different for safe harbor 401(k) plans. Employers can match their employee’s contribution dollar-per-dollar up to 3% of their salary. If they contribute more than 3% but less than 5%, it becomes 50 cents to a dollar.

Making non-elective contributions is also possible, but these must be 3% of each qualified employee’s compensation. You must choose between these two options annually since safe harbor plans make employer contributions mandatory.

Employers have two choices for their contributions to SIMPLE 401(k) plans. Employers can match their employee’s contribution dollar-per-dollar, up to 3% of their salary or make a non-elective contribution equivalent to 2% of each eligible person’s pay.

Lastly, combined contributions also have limits. You cannot exceed $61,000 for 2022 or 100% of your annual compensation. Knowing these numbers can seem tedious but crucial. You may have to pay additional taxes if your contributions exceed these limits.

Ideally, you start withdrawing from your 401(k) after you turn 59 ½. Although it’s still taxed, you avoid the additional 10% tax penalty for an early withdrawal. However, these become tax-free if you have a Roth 401(k).

Early withdrawal penalties apply even if you need the distribution because of a hardship. However, a penalty-free distribution may occur in some situations. These include:

• Unreimbursed medical expenses amounting to more than 7.5% of your AGI
• A court requires you to provide money to a divorced spouse, children or other dependents
• Death or total and permanent disability of the 401(k) participant
• Opting to receive a series of substantially equal payments

When you turn 72, you must take the required minimum distributions, whether or not you have retired. You receive it by April 1 of the year after you turn 72.

A 401(k) is only one way to save up for retirement, but it isn’t your only option. For organizations that require a waiting period before you qualify to make contributions, having another retirement plan can come in handy. Instead of spending the portion of your salary intended for your 401(k), why not invest in an Individual Retirement Account?

MoneyGeek’s guide explores two potential IRAs — traditional and Roth. Both allow you to build a nest egg in preparation for retirement, offer multiple investment options and provide tax advantages. The retirement plan that is best for you depends on your preferences.

Almost anyone can open a traditional IRA because its only qualification is taxable compensation. It’s a sought-after type of IRA because it allows you to enjoy multiple tax benefits.

First, your contributions use pre-tax dollars and are deductible, making your taxable income smaller. Second, your account allows your funds to grow tax-deferred. The only time you’ll be taxed is when you begin to make withdrawals, making it an excellent option for individuals who see themselves in a lower tax bracket in their golden years.

You can contribute up to $6,000 for 2022 to a traditional IRA. IRA owners who are 50 or older can add catch-up contributions up to $1,000.

Like a 401(k), you must begin taking distributions when you turn 72. However, you’ll pay an additional 10% tax penalty if you make withdrawals before you turn 59 ½. However, it’s crucial to note that several penalty-free scenarios for early withdrawals exist.

Your eligibility to open a Roth IRA is affected by your income. To contribute the maximum amount of $6,000, your Modified Adjusted Gross Income (MAGI) must be below $144,000. Roth IRA owners who are married and file jointly must have a MAGI not exceeding $214,000. Catch-up contributions for Roth IRAs also have a $1,000 limit for those 50 or older.

You use after-tax dollars for your contribution, so although you can’t deduct it from your taxable income, your earnings grow tax-free. Roth IRAs are best suited for individuals who think they’ll be in a higher tax bracket by the time they retire.

All withdrawals you make after turning 59 ½ are tax-free and penalty-free unless you’ve had your account for less than five years. While traditional IRAs require you to take mandatory distributions, Roth IRAs do not.

Having a 401(k) is an excellent option to build a nest egg for your golden years, but it can be confusing if you’re unfamiliar with it. MoneyGeek gathered the most commonly asked questions to provide you with more information.

Ensuring that you’re in a good place financially by your golden years requires a lot of work. More than having a solid retirement savings plan, you also need to consider other factors, like knowing how to budget and spend wisely.

Fortunately, there are more than enough resources online, allowing you to explore these areas further. Here are several resources you can peruse at your own time that may provide essential information.

• Save It Like You Mean It: Retirement may seem like a long way off, but it’s never too early to start preparing for it. Learn several tips to ensure a sizable retirement income for the future.
• Smart Spending in Retirement: Most seniors live on a fixed income, so having your savings in place is excellent. However, you must also have strategies for smart spending to ensure you don’t experience financial stress.
• Planning for Financial Success and Happiness: Financial planning isn’t something only people in their 40s or 50s can appreciate. The earlier you can establish your long-term and short-term financial goals, the sooner you can develop strategies to achieve them.
• How to Start Saving and Investing: See how you can achieve financial security by making the most of savings accounts and retirement plans. You can also read about how to invest gradually.
• How to Make Rational Investing Choices During Stressful Times: Most people aren’t familiar with the ins and outs of investing, and they’re hesitant. This page walks you through a series of steps to help you make wise investment decisions, even in times of stress.