401(k) plans can be confusing and may lead to more questions than answers. Which plan is right for you? How much should you contribute? When should you start contributing? How do contributions impact your taxes? What are the benefits? How do withdrawals and contributions work? Where do you even start? If you’re fortunate to have an employer that offers a 401(k) plan, that may help with some of the confusion. You may still be left wondering if it’s worth participating in it at all.
Contributing to a 401(k) plan is a great tax and retirement saving deal that helps an employee accumulate a retirement nest egg on a tax-advantaged basis.
With a 401(k) plan, you can opt to set aside a portion of your wages in a qualified retirement plan. By electing to set aside this portion of your wages in a 401(k) plan, you’ll reduce your gross income and defer taxes on that portion set aside until it (adjusted by earnings) is distributed to you in the future. It will either be distributed from the plan or from an IRA, or other plan, that you roll your proceeds into after leaving your job.
Tax benefits of 401(k) contributions
Your wages or other compensation will be reduced by the pre-tax contributions that you make, which will save you current income taxes. But the amounts will still be subject to Social Security and Medicare taxes. If your employer’s plan allows, you may instead make all, or some, contributions on an after-tax basis. These are Roth 401(k) contributions. With Roth 401(k) contributions, the amounts will be subject to current income taxation, but if you leave these funds in the plan for a required time, distributions (including earnings) will be tax-free.
Your elective contributions — either pre-tax or after-tax (again, with a Roth 401(k)) — are subject to annual IRS limits. In 2023, the maximum amount permitted is $22,500. When you reach age 50, if your employer’s plan allows, you can make additional “catch-up” contributions. In 2023, that additional amount is up to $7,500. Which means if you’re 50 or older, the total that you can contribute to all 401(k) plans in 2023 is $30,000. Total employer contributions, including your elective deferrals (but not catch-up contributions), can’t exceed 100% of compensation or, for 2023, $66,000, whichever is less.
In a typical plan, you’re permitted to invest the amount of your contributions (and any employer matching or other contributions) among available investment options that your employer has selected. Periodically review your plan investment performance to determine that each investment remains appropriate for your retirement planning goals and your risk specifications.
Limitations on taking withdrawals from your 401(k)
Another important characteristic of these plans is the limitation on withdrawals while you’re working. Amounts in the plan attributable to elective contributions aren’t available to you before one of the following events:
- Retirement (or other separation from service),
- Reaching age 59½,
- Plan termination, or
Eligibility rules for a hardship withdrawal are strict. A hardship distribution must be necessary to help deal with an immediate and heavy financial need.
As an alternative to taking a hardship or other plan withdrawal while employed, your employer’s plan may allow you to receive a loan, which you pay back to your account with interest.
Contribute enough to get the matching contributions
Employers may opt to match 401(k) contributions up to a certain amount. Although matching is not required, surveys show that most employers offer some type of match. If your employer matches contributions, you should make sure to contribute enough to receive the full amount. Otherwise, you’ll lose out on free money!