Definition of the day: 401(k) An account to help you invest money to save for retirement.
Unifiers! You called! We answered. This week, by popular request, we bring you the skinny on 401(k)s.
First, let’s meet the family! While the term "401(k)" is thrown around a lot, there are actually a bunch of different kinds. They’re often called “K Plans.” If you work for a big business, you’re most likely to have a traditional 401(k) or safe harbor 401(k). SIMPLE 401(k)s are geared towards smaller businesses. Solo 401(k)s are for tiny itty bitty companies, or the self-employed. And Roth 401(k)s are a wild child, so the fast facts below don’t necessarily apply. More on Roth’s here.
Here’s what’s up with K Plans:
401(k)s are pre-tax. That means the money you put in them doesn’t get taxed until you withdraw from the account when you retire. That saves you money in the short-term.
Free money alert! Most companies (76%, but who’s counting?) will give you extra cash for your 401k. They might give you a contribution, which is just free money, or they might offer a 401(k) match. A match means that you have to give a little for your employer to give a little. Typically with a match, the more you put into your account, the more your employer matches, up to a point.
Pay attention to vesting. Some employers will set aside money for your 401(k) but wait to give it to you to encourage you to stay at the company. If you are considering leaving a job, it’s good to see if your 401(k) has vested yet. If not, it might be worth sticking it out a few more months to get that free money.
There is a limit to how much money you can put in your 401(k) each year. If you meet that limit you’ve “maxed out.” For traditional and safe harbor plans (big employers) the limit is $18,500. For simple plans (small companies) it’s $12,500. There’s also a cap on the total amount that can be added (your contributions + your employer’s) each year. That limit is $55k for traditional and safe harbor plans, and for SIMPLE plans it’s a percentage of your pay.
K plans are designed for retirement, so you are not supposed to withdraw money until you’re 59 and ½ (Random? We know.) or 55 in certain cases. Bottom line? If you withdraw early, you pay a price. In addition to paying taxes on your money, you have to surrender another 10% of your money as a penalty for early withdrawal. Yeeps! Stay away.
You may hear people talking about taking out loans on their 401(k)s. You can do it, but you probably shouldn’t. Most of us are already struggling to save enough for retirement.
You often have some choice about where your money gets invested. The rule of thumb is to invest in riskier investments when you’re younger and safer things as you get closer to retirement. What do we mean by risky? More on that here.
So what if you leave an employer? You have a couple options. You can often leave your money in the same account with your old employer, and it will keep growing interest. If you have a new employer, they may also let you move, or “rollover”, your old 401(k)s into your new 401(k) plan. If that doesn’t pan out, you can roll the 401(k) into something called an “IRA”-Individual Retirement Account that you set up independent from your employer. The main reason you might want to move money out of old 401(k) accounts is that you get charged several different fees by the companies who manage your 401(k)s. If you have fewer accounts you may have fewer fees to pay.
Last, but not least, the thing you’re probably sick of hearing: The earlier you start investing in your 401k, the better. If that makes you feel overwhelmed, we hear you! And we made a new newsletter section just for you. “Money tricks anyone can try.” If you’re not signed up for the newsletter yet, get hoppin'! Let’s get money smart, together.
This week take a peek at this tool and see for yourself why saving earlier is better. Plug is some guesses about how much you could save, and then play around with the age when you start investing. Now matter your bank account status, we hope it encourages you to jump in.