401(k): The Basics

If you're like me, then you have been lectured about how important it is to save for your retirement. From my experience, the main reoccurring point was that I needed to learn more about my company's 401(k) plan. But, the moment I saw the packet with numbers and percentages and the finance terminology, I was admittedly over my head.

This post will attempt to demystify the 401(k) for all of you. So, let's get started! Any important points or anything I think requires further explanation will be underlined and added to a list below.

What is a 401(k) anyway?

It's a retirement savings plan through your employer that allows you to invest pre-tax money from your paychecks. You choose the amount that you want to contribute every month, which then gets withdrawn from your paycheck and deposited into your 401(k) account. There are several different types of 401(k) plans, but I'm going to focus mainly on the traditional plans.

Fun fact: the reason that it's called a 401(k) is because of its tax code designation.

How is my employer involved with this?

In some cases, a company may offer to match their employees' contributions to their 401(k) plan. A certain amount, usually a percentage, will be established and then the employer will match the monthly contribution up to that specified limit.

Example: Jennifer (24) has been working for a company for 1 year and has a salary of $40000 USD. Her employer's retirement savings plan offers a 401(k) with an annual 3% match. This means that every year they are willing to contribute money to Jennifer's plan up to 3% of her annual salary, or $1200.

Now, it's important to say that everyone has an annual contribution limit set by the IRS (Internal Revenue Service). As of the year that this is being written, 2016, the annual limit for an employee to contribute to their 401(k) account is $18000 USD and the annual limit for additions to the plan, including employer contributions, is either 100% of the employee's compensation or $53000 USD.

Why is this important to me?

Well, everyone has their own idea of how to spend or save their money but this is a great way for young people, myself included, to save money for their retirement. I've come to appreciate the idea of a 401(k) because, to me, it's a way of saving money without necessarily having to do anything. On top of that, having an employer match my contributions means I'm basically getting money for free!

Some people may balk at what seems like a small amount, think about it per year. If I put $100 USD per month into my 401(k) and my company matches me up to 3% of my salary, that's another $100 USD per month that I'm getting from my employer for free! This all adds up to $2400 USD per year and if I work at this company at the same salary for 40 years, that's a total of $96000 for when I retire, half of which was matched by my company!

Now, as you advance and grow in your career, you'll have a higher salary and will be able to contribute more and your employer will then match more... on and on.

In the wise words of my dad... every little bit counts towards your retirement. (Yes, he actually says that. All the time.)

When do I get the money, then?

Good question! You're able to withdraw the money (known as distribution) whenever, but it has to be under one of the following conditions, as stated by the IRS:

• The participant dies, becomes disabled, or otherwise has a severance from employment.
• The plan terminates and no successor defined contribution plan is established or maintained by the employer.
• The participant reaches age 59½ or incurs a financial hardship.

However, you have to be careful if you access the finds earlier than specified, as you'll be hit by an additional 10% tax on top of the existing state and federal taxes that will be applied on the withdrawal.

Once you've reached the age of 70½, the required minimum distributions (RMD) kick in and you're required to withdraw a minimum amount on a monthly basis from your 401(k) plan unless you're still working and the plan that you have allows for deferment until retirement.

The amount that you receive is counted as income and is taxed accordingly at both the state and federal levels.

Final notes

The information above is a way-oversimplified version that explains what I believe to be most important to someone who don't have previous exposure to the topic and wants a general idea. If you think anything can be added or changed, or if you have any questions, feel free to include it in a comment below or on our Twitter account!

Important Terms

1. pre-tax money - as the money that you earn as part of your salary is taxed at both the state and federal level when it's paid to you, the money deposited into the 401(k) account comes out from your paycheck before these taxes are applied.
2. distribution - the term that the IRS uses to refer to withdrawals from an employer-sponsored retirement plan.
3. required minimum distributions (RMD) - this is the minimum amount that you are required to withdraw, starting the year that you turn 70½. It is determined by using the balance of your account from December 31 of the previous year as well as a life expectancy factor established in a table published by the IRS.

References

IRS.gov

WSJ

Investopedia