What Is 401k, And How It Works
A 401k plan is an employer-sponsored retirement account that allows employees to save for retirement and enjoy certain tax advantages. Many financial advisors consider 401k plans to be great ways to save for retirement, which is why they encourage their clients to use them to their fullest extent.
For those who want to learn more about the power of the 401k plan and how it can help supercharge your retirement and help pay for senior care when the time comes, we’ve put together an in-depth guide below:
Why should I have a 401(k) plan?
The 401k plan is a powerful retirement savings tool because it gives employees a tax-advantaged means of saving for retirement. The specific tax advantage you receive depends on the type of plan you have, which we will discuss in the next section.
The “employer match” that often comes along with 401k plans is a beneficial aspect of this savings tool. To incentivize people to save for retirement, employers who offer 401k plans to their employees typically “match” employee contributions up to a certain threshold.
For example, an employer might match every dollar you contribute to your 401k, up to 3% of your salary. That means there’s often “free” money waiting for you when you make 401k contributions.
Types of 401(k) plans
There are two main types of 401k plans: the Roth 401k and the Traditional 401k. The Roth 401k allows you to contribute post-tax income and enjoy tax-free growth on your investments. This will enable employees to pay their income tax today and not worry about paying income tax or capital gains tax on their investments once they retire.
The Traditional 401k allows employees to contribute pre-tax income and defer paying income taxes until they retire. Contributing to a traditional 401k plan allows you to reduce your tax burden today and defer your tax payment to when you’re retired and likely in a lower tax bracket.
Which type of 401(k) plan is right for me?
Unfortunately, you might not have a choice regarding the type of 401k account you have. Since 401k’s are employer-sponsored accounts, the accounts your employer offers are up to their discretion. This means they may only offer a single type of account, although some employers offer a choice between the two types.
If you have a choice, it’s probably best to enlist a financial advisor’s help. The best account for you depends on how much money you’re making now and how much money you plan to have in retirement.
How does an employer match work?
As we mentioned, employers will typically match employees’ contributions up to a certain percentage of their salary. The exact process depends on your employer, but typically all you have to do to get the employer match is set up a recurring contribution to your 401(k) plan.
Remember, employers can structure their match in a few different ways. Some may match 100% of your contributions up to a certain percentage of your salary, whereas others may only match 50% of your contributions. It’s essential to familiarize yourself with how your employer structures their match to ensure you’re making the most of it.
The pros and cons of using a 401(k) plan
While 401k plans sound great, as with anything in life, they have both benefits and drawbacks. In order to help you make a more informed decision on whether or not to use a 401k, we’ve put together a list of pros and cons below:
- 401k plans give employees a great tax-advantaged means to save for retirement.
- Often, employers offer a 401k match plan, which provides a monetary incentive to save
- 401k’s are a great way to supplement other forms of retirement income.
- 401k contributions are capped ($20,500 for 2022).
- You cannot withdraw without penalty until age 59.5.
- 401k’s have required minimum distributions (RMDs) after age 72.
When can you withdraw funds from a 401(k) plan?
Unfortunately, one of the drawbacks to the 401k plan is that there’s a minimum age to withdraw. Since a 401k is a type of retirement account, you cannot withdraw without penalty at any time. To withdraw from your 401k without penalty, you must be at least age 59.5. Once you reach age 59.5, you can make withdrawals from your 401k and use the money for whatever you would like, whether that be living expenses or senior care costs.
It is important to note that those with 401k plans must withdraw after age 72. This requirement is known as a required minimum distribution or RMD. While this may not seem like a big deal, some people may not need the money in their 401k and would prefer it to continue growing.
Is a 401(k) plan worth it?
So long as your employer offers a 401k match, making contributions to your 401k is a no-brainer. This is because you’re essentially turning down free money if you don’t contribute enough money to get your full match.
Even if your employer doesn’t offer a match program, contributing to a 401k plan is likely a great idea. These retirement accounts provide great tax advantages; once you’ve retired, you can use the funds can for anything, including the cost of senior care.