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401(k) Plans: Explained in Six Questions

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The complicated stuff in life gets a little less complicated when you break it down into six basic questions: What, Why, Who, Where, When and How?

What is a 401(k)?

A 401(k) is a type of retirement savings plan offered by employers. There are two types: a traditional 401(k) and a Roth 401(k). Both offer tax advantages.

How does a 401(k) work?

You’ll typically hear about your company’s 401(k) plan during employee orientation, but check with your HR department on the specifics if you missed this.

Here’s the gist: once you’ve set up your account, you can make regular contributions by withholding an amount from your paycheck. For 2020 and 2021, you can contribute up to $19,500 annually. If you’re 50 or older, you’re allowed to contribute an additional $6,500.

Some employers may offer matching contributions, which means for every dollar you contribute up to a certain point, your employer will also contribute some amount. Translation: free money.

Where do taxes come into play? 

With a regular 401(k), you contribute pre-tax dollars from your paycheck and then are typically taxed on your withdrawals once you reach 59 ½. 

With a Roth 401(k), you pay taxes on your contributions up front, but your typical eligibility for withdrawals after age 59 ½ are tax free (provided you follow the plan rules). 

Note: both of these plans allow some exceptions for early withdrawals. You’ll want to check the IRS website for the details. 

Who can contribute to a 401(k)?

First make sure your company offers one. If you’re self-employed or your employer doesn’t offer a 401(k), you won’t be eligible. The good news is that there are other retirement plan options available. 

From there, specific 401(k) requirements may depend on your employer, but at minimum, you’re allowed to participate if you are 21 years or older and have been with your company for at least a year. 

When can you withdraw from your 401(k)?

With both a traditional and Roth 401(k), you must be at least 59 ½ years old, or meet other IRS requirements before you can start taking withdrawals. Early withdrawals from either of these accounts may result in a 10% tax penalty, on top of any other taxes. 

For traditional 401(k)s, the IRS generally requires that you take requirement minimum distributions (RMDs) in the year you turn 70 ½. However, due to a change in the law (the SECURE Act), the RMD age has been raised to 72. This age increase came into effect on January 1, 2020. For individuals who turned 70 ½ prior to the effective date, you are still subject to the old RMD rules. Check with the IRS to get the full details on the timing of your RMD obligations. Roth 401(k)s do not have RMDs.

Why do 401(k)s matter?

Contributing early and regularly to your 401(k) can really add up over the long run, thanks to the power of compounding. Check out our 401(k) guide to see just how much your contributions could add up.

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