Enrolling in a 401(k) plan is a great way to save money for retirement at any point in your professional career, as well as a key aspect of employee benefits management. However, before getting started, it's important to understand exactly what a 401(k) is, what to expect and how to get the greatest contribution benefits.
What is a 401(k) plan?
A 401(k) plan is an employer-sponsored retirement savings plan that helps employees steadily put money away for retirement. These programs have many different components, and here's what you need to know:
- Both public and private for-profit companies offer 401(k) plans. Some employers will allow you to set up a 401(k) plan immediately after you start working, while others will enforce a waiting period of usually one month to one year before you are eligible.
- A percentage of your paychecks will be put into savings. Before you receive each paycheck, a designated percentage will be deducted and set aside in a separate 401(k) account.
- Some employers offer a company match. The company match refers to the amount that an employer contributes to 401(k) accounts. Companies will match up to a certain percentage of your contribution – usually 3 to 6 percent of your paycheck – which helps your 401(k) grow even more.
- The maximum amount you can put into your 401(k) changes each year. The cost-of-living index and inflation are taken into account when considering this number. According to the IRS, the maximum amount you can contribute to your 401(k) plan increased from $17,500 to $18,000 in 2015.
- The IRS also imposes a "catch-up contribution" limit. If you are 50 or older, you may be eligible to add an additional $6,000 to your 401(k) on an annual basis, according to the IRS.
- Enrolling in a 401(k) plan will reduce your taxable income base. Money designated for your 401(k) is taken before state and federal income taxes are applied to your paycheck. This will reduce your take-home pay, but also require you to pay less money in taxes.
- The money in your 401(k) account is not taxed until you start making withdrawals. As you will likely have no income during retirement, your personal tax rate will be lower than when you were working, and you will therefore owe less money to the IRS.
- You can start accessing your money as early as age 59 and one-half. Prior to that age, you will be subject to an early withdrawal penalty. However, if you become completely disabled or are over age 55 and have been let go by your employer, you will be exempt from the penalty.
- You must start withdrawing from your 401(k) by age 70 and one-half. If you are still a full-time employee with the company that sponsors your plan, you are exempt from this rule.
- If you leave your current employer, there are options for what to do with your 401(k). Typically, there are four things you can do: Withdraw your entire balance as a cash payout; roll your account balance over into an IRA; roll your account balance over to a plan with your new employer; or, if allowed by the employer, leave the balance where it is.
Why is this a good savings option?
One of the largest benefits of having a 401(k) plan is how simple it is to start and maintain. After the initial enrollment, you are not required to do any additional work unless you want to make changes to the contribution amount. It is completely separate from your standard savings or checking accounts, so you will be able to consider larger purchases like homes, cars or vacations without being tempted to dip into your retirement savings.