Whether your retirement plans involve writing your memoir from a lovely little seaside cottage, a heated game of bocce against your (*ahem* sore loser) neighbor, or hitting up every farmers market in a 50-mile radius, a 401(k) is one savings strategy you can use to save money to get you there.
Simply put, a 401(k) is a mechanism for saving retirement funds by making pre-tax contributions through deductions from payroll. Some plans offer a 401(k) employer match, which can be the equivalent of getting “free money” from an employer.
A Quick Breakdown on 401(k) Plans
A 401(k) is an investment plan many employers offer their employees as a way to save for retirement. Employees can contribute either a percentage of or predetermined amount from each paycheck and, in some cases, the contributions can be matched by the employer up to a certain amount.
These deferred wages, also called “elective deferrals,” aren’t typically subject to federal income tax withholding, and are not listed as taxable income on the employee’s annual return.
If someone is self-employed, they can contribute to a one participant 401(k) plan plan with the same rules and requirements as an employer-sponsored 401(k) plan. Similarly, 457(b) plans can be used for public sector employees, and 403(b) plans for public schools and certain tax-exempt organizations.
Advantages of Participating in a 401(k)
A few advantages to participating in a 401(k) :
1. Investment gains and elective deferrals to 401(k) plans are not subject to federal income tax until they’re distributed, which is typically when:
• The participant reaches the age of 59½
• The participant becomes disabled, deceased, or otherwise has a severance from employment
• The plan terminates and no subsequent plan is established by the employer
• The participant incurs a financial hardship
2. Elective deferrals are 100% vested. The participant owns 100% of the money in their account, and the employer cannot take it back or forfeit it for any reason.
3. Participants choose how to invest their 401(k). The plans are mainly self-directed, meaning participants decide how they’d like to invest the money in their account. This could mean mutual funds or exchange-traded funds (ETFs) which invests in a wide array of sectors and companies, but typically doesn’t include investing in individual companies and stocks.
Investment tactics might vary from person to person, but by understanding their goals, investors can decide whether their portfolio will have time to withstand market ups and downs with some high-risk, high-reward investments, or if they should shift to a more conservative allocation as they come closer to retirement.
What About 401(k) Vesting Schedules?
“Vesting ” means “ownership” in a retirement plan. The employee will vest, or own, some percent of their account balance. In the case of a 401(k), being 100% vested means they’ve met their employer’s vesting schedule requirements to ensure complete ownership of their funds.
Vesting schedules, determined by 401(k) plan documents, can lay out certain employer vesting restrictions that range from immediate vesting to 100% vesting after three years to a schedule that increases the vested percentage based on years of service. Either way, all employees must be 100% vested if a plan is terminated by the employer or upon reaching the plan’s standard retirement age.
How Does a 401(k) Match Work?
A 401(k) match is an employee benefit that allows an employer to contribute a certain amount to their employee’s 401(k) plan. The match can be based on a percentage of the employee’s contribution, up to a certain portion of their total salary or a set dollar amount, depending on the terms of the plan.
Not all employers offer this benefit, and some have prerequisites for participating in the match, such as a minimum required contribution or a cap up to a certain amount.
Meeting with an HR representative or a benefits administrator is a one way to get a better idea of what’s possible. Learning the maximum percent of salary the company will contribute is a start, then the employee can set or increase their contribution accordingly to maximize the employer match benefit.
Benefits of a 401(k) Employer Match
According to a report from Fidelity Investments , the average employer 401(k) match reached a record high of 4.7% in 2019 and “boosted the average total savings rate to an all-time high of 13.5%.”
Many employees are taking advantage of this benefit. Some reasons they could benefit:
It’s Basically “Free Money”
An employer match is one part of the overall compensation package and another way to maximize the amount of money an employer pays their employees. Those employees could be turning their backs on free money by not contributing to an employer-matched 401(k) plan.
Reducing Taxable Income
According to FINRA , “with pre-tax contributions, every dollar you save will reduce your current taxable income by an equal amount, which means you will owe less in income taxes for the year. But your take-home pay will go down by less than a dollar.”
If a participant contributed $1,500 a year to a 401(k), they’d only owe taxes on their current salary minus that amount, which could save some serious money as that salary grows.
The Most Common Employer Match Formulas
Not all employer matches are created equal.
According to a recent report from Vanguard , “How America Saves,” among the 150 distinct match formulas administered through their employer-matched 401(k) plans in 2018:
• 70% of plans used a single-tier match formula, with the most commonly cited being $0.50 on the dollar on the first 6% of pay.
• 21% of plans used multi-tier match formulas, e.g., dollar-on-dollar on the first 3% of pay and $0.50 on the dollar on the next 2% of pay.
A Sample Employer Match 401(k) Scenario
For the sake of breaking a few things down, here’s a retirement saving scenario that can illuminate how 401(k) matching works in real life:
Let’s say a person is 30 years old, with a salary of $50,000, contributing 3% of their salary (or $1,500) to a 401(k). Let’s also say they keep making $50,000 and contributing 3% every year until they’re 65. They will have put $52,500 into their 401(k) in those 35 years.
Now let’s say they opt into an employer match with a dollar-for-dollar up to 3% formula. Putting aside the likelihood of an increase in the value of the investments, they’ll have saved $105,000— with $52,500 in free contributions from their employer.
That’s a no-cost way to increase retirement savings by 100%.
How Much Should a Participant Contribute?
The average 401(k) employee contribution amount, according to Fidelity , reached a record level of $2,370 in 2019. Still, there’s no across-the-board amount that will work for everyone.
When deciding how much to contribute to a 401(k) plan, many factors might be considered to take advantage of a unique savings approach:
• If a company offers a 401(k) employer match, the participant might consider contributing enough to meet whatever the minimum match requirements are.
• If a participant is closer to retirement age, they’ll probably have a pretty good idea of what they already have saved and what they need to reach their retirement goals. An increase in contributions can make a difference, and maxing out their 401(k) might be a solid strategy.
A retirement calculator can also be helpful in determining what the right contribution amount is for a specific financial situation.
Are There 401(k) Contribution Limits?
In addition to the uncertainty that can come with choosing how much to contribute to a 401(k), there’s the added pressure of potential penalties for going over the maximum 401(k) contribution limit.
Three common limits to 401(k) contributions :
1. Elective deferral limits: Contribution amounts chosen by an employee and contributed to a 401(k) plan by the employer. In 2020, participants can contribute up to $19,500.
2. Catch-up contribution limits: After the age of 50, participants can contribute more to their 401(k) with catch-up contributions. In 2020, participants can make up to $6,500 in catch-up contributions.
3. Employer contribution limits: An employer can also make contributions and matches to a 401(k). The combined limit (not including catch-up contributions) on employer and employee contributions in 2020 is $57,000.
If participants think their total deferrals will exceed the limit for that particular year, the IRS recommends notifying the plan to request the difference (an “excess deferral ”) “be paid out of any of the plans that permit these distributions. The plan must then pay the employee that amount by April 15 of the following year (or an earlier date specified in the plan).”
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