If you're like most Americans, there will come a time in your life when you're no longer working full-time. And while countless retirees rely heavily on Social Security to pay their living expenses, for many, those benefits just aren't enough.
Enter the 401(k). It may sound like some sort of space-age robot, but a 401(k) is actually a crucial financial tool for working Americans. A 401(k) plan is a retirement savings program that's sponsored by an employer. If you participate in your company's plan, then you can choose the amount of money to contribute to your 401(k) account, up to a certain limit. You can then invest that money based on the choices offered by your plan with the goal of growing your balance to fund your retirement.
How 401(k) plans work
Based on subsection 401(k) of the Internal Revenue Code, a 401(k) plan allows you to save for retirement and reap some up-front tax benefits along the way. If you sign up for a 401(k) plan, you'll get to decide how much of your salary to contribute on a pre-tax basis. For 2018, anyone under 50 can contribute up to $18,500 per year to a 401(k). Workers who are aged 50 and older are allowed an additional $6,000 catch-up contribution for a total of $24,500 a year.
Once you fund your 401(k), you'll need to decide how to invest your money. While you'll be limited to the options offered by your plan, it'll be up to you to choose your own investments, which may include stock mutual funds, bond mutual funds, or money market funds.
Some employers offer 401(k) matching programs, pitching in a certain amount of money for every dollar you contribute. Employer matches usually come with limits based on your salary. For example, an employer might contribute $0.50 for every dollar you contribute, but only for contributions of up to 6% of your salary. Employer matches are essentially free money, so it pays to save the maximum amount that your employer will match.
Because the purpose of a 401(k) is to help you save for retirement, you must wait until you reach age 59-1/2 before you start taking withdrawals. Any money you remove from your 401(k) prior to age 59-1/2 could be subject to a 10% early-withdrawal penalty.
Once you reach age 59-1/2, you're free to withdraw money from your 401(k) as you please, at which point you'll pay income tax on whatever you choose to take out. Furthermore, when you reach age 70-1/2, you'll be required to start taking minimum distributions from your account.
401(k)s versus IRAs
The primary difference between a 401(k) plan and an IRA is that 401(k)s are employer-sponsored. Traditional or Roth IRAs don't come with employer matches like many 401(k) plans do. On the flip side, IRAs typically offer a wider range of investment options than 401(k)s.
Under both types of plan, you're allowed to start taking distributions starting at age 59-1/2. However, if you have a Roth IRA, you can withdraw your principal contributions (but not earnings) at any time without penalty.
Both 401(k)s and traditional IRAs are funded with pre-tax dollars, which can help lower your up-front tax burden. However, any distributions you take in retirement will be taxed as ordinary income. When you contribute to a Roth IRA, you do so with after-tax dollars, which means you don't save on your taxes up front. However, when the time comes to withdraw money in retirement, your distributions are tax-free. Furthermore, while both 401(k) plans and traditional IRAs impose required minimum distributions beginning at age 70-1/2, Roth IRAs allow you to leave your money untouched for as long as you see fit.
If your employer offers a 401(k), it pays to sign up and start contributing as early as you can. The more time you give your money to grow, the greater your chances of amassing a sizable nest egg in time for retirement.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!