What Is a 401(k) and How Much Should You Save for It?

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You’re never too young to start saving for retirement. Today, people live much longer, and many older adults run out of retirement savings.

There are several different types of retirement savings accounts, and 401(k) plans are some of the most common ones. If your employer offers a 401(k), you’d be wise to learn about the benefits of these retirement accounts.

What Is a 401(k) Plan?

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Section 401(k) of the United States tax code makes it possible for employees to maintain 401(k) accounts. That’s where these financial tools get their odd name. A 401(k) is a retirement savings account. Year after year, employees deposit a portion of their income into the account. Then, a financial institution invests that money.

Different 401(k) plans may have different investment standards. Often, 401(k) monies are invested in mutual funds. Although investment earnings are never guaranteed, the strategic investment of this money by a professional usually results in a 401(k) account becoming far more valuable than the total money deposited. This money earns more interest through investment than in a traditional savings account. 

How Does a 401(k) Plan Work?

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For a traditional 401(k) plan, employees choose how much money each pay period will go towards their 401(k). The amount appears on their pay stub as a deduction, and the deduction comes out of the employee’s gross income before taxes.

In many companies, employers agree to match 401(k) contributions. Some employers match 100% of what employees contribute. This means that if you contribute $50 per paycheck to your 401(k), your company will contribute an additional $50 to your 401(k). Other employers simply give a flat dollar amount to each employees’ 401(k) account each year. Still, other businesses do not make any contributions.

All the money the employee has contributed to the 401(k) throughout the year qualifies as a tax deduction at tax time. You pay taxes on the money when you withdraw your contributed income from a traditional 401(k) plan.

With a Roth 401(k), contributions come from your net pay after taxes have already been deducted from your gross income. This takes care of your income tax obligation. The contributions do not qualify as a tax deduction, and there are no additional taxes to pay when you withdraw the money at retirement age. Roth 401(k) plans are far less common than traditional ones. 

What Are the Rules for a 401(k)?

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There are annual contribution limits for 401(k) plans. Each employee can only contribute up to $20,500 to their 401(k) in a year. For an employee who receives a monthly paycheck, that averages to just over $1,700 per check. Contributions made by the employer are not included in this limit, but the sum of employer and employee contributions cannot exceed $61,000 for a single year. 

Employees aged 50 and older can contribute more to their 401(k) each year. These additional contributions are called catch-up contributions, and they are allowed because these employees are closer to retirement age, making their saving needs even more immediate. Older employees can contribute $6,500 over the usual limit each year. These additional contributions are still payroll deductions. Among employers who match employee contributions, some will not match catch-up contributions. 

Since a 401(k) plan is a retirement account, the intention is that you will not withdraw any of the money before you retire. However, the money belongs to you, so you do have the option of withdrawing early. If you are 59.5 or older when you make a withdrawal, there are no penalties. If you are younger than retirement age, any amount that you withdraw from your 401(k) counts as income for that tax year, so you will pay income taxes on the money. There is also a 10% penalty for early withdraw. If you take $10,000 out of your 401(k) when you are 40, you will pay $1,000 in penalties, and you will also owe income taxes on the money. 

How Much Should You Save for Your 401(k)

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There are a few key factors to consider when deciding how much to save in your 401(k). Remember that 401(k) contributions are deductions from your paycheck. It certainly does not make sense to make significant 401(k) contributions while falling behind on monthly bills. Carefully consider your monthly budget to determine how much of your pay you can go without. 

Balance your need to save for retirement with the current need to have enough money in an accessible savings account for financial emergencies. A 401(k) is a retirement savings account. The intention is not to withdraw the money until you retire, so you should budget so that you can make regular contributions to both your 401(k) and your regular savings account. Personal finance experts suggest that all households keep three to six months of household bills in a savings account. Some people tap into their 401(k) early when they run into financial hardships. There is a tax penalty for doing so. 

To decide how much you need to save in your 401(k) account, try to get a clear understanding of your total income during retirement. Are you eligible for a pension or some other type of monthly benefit? Is there a way to get a reliable estimate of the amount of social security you will receive each month? Do you have access to retirement accounts with higher contribution limits?

There is no golden number for 401(k) savings. Instead, each person should make the best choice, given their current budget and proposed future circumstances. A financial advisor is an excellent professional to help you decide how much you need to save from each paycheck.

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