The 401(k) is one of the best tools for retirement savers, so it's important to understand the basics of how these accounts work and what their limitations are. This will help you come up with a solid retirement savings plan and enjoy the huge tax breaks a 401(k) offers.
1. Contribution limits
The 401(k) provides such fantastic tax benefits (see the next section for more on this) that the government limits how much money you can put into yours. The annual contribution limit for 401(k)s is pegged to inflation, so it tends to go up from one year to another. For 2018, the annual contribution limit is $18,500. If you're 50 or older, you get an additional catch-up contribution of $6,000 per year, meaning you can contribute a total of $24,500.
Some employers will make matching contributions, which means they'll contribute some money to your account -- but they'll only make a contribution if you do. Those matching contributions don't count toward the $18,500 limit.
2. Tax breaks
Traditional 401(k)s allow you to invest your pre-tax wages, so the money comes out of your paycheck before your employer calculates how much of your wages to withhold in taxes. Because those contributions reduce your taxable income, you end up paying less in taxes. In fact, you don't pay any taxes at all on the funds in your traditional 401(k) until you withdraw them in retirement.
Roth 401(k)s work a bit differently: You have to pay taxes on the money you contribute to the account, but after you retire and start taking money out, you don't have to pay income taxes on the withdrawals.
3. Withdrawal age
The money you put into your 401(k) is supposed to be used for retirement income, so if you take any money out of the account before you reach a certain age, you'll pay a 10% early withdrawal penalty. Then again, it's usually not a good idea to tap your 401(k) money early, as doing so can cripple your future income from that account.
You see, compound interest makes early contributions to your 401(k) far more valuable than later ones. The longer the money sits in your account, the bigger it will get. The flip side of this equation is that taking money out early will cost you a lot more than you'd think. If you withdraw $1,000 from your 401(k) 30 years before retirement, you're not just losing $1,000 in retirement income, you're losing all the earnings you would have gotten from that money. If your $1,000 had stayed in the account and earned an average annual return of 8%, it would have turned into $10,063 by the time you retired.
The earliest you can withdraw money from your traditional 401(k) without paying the penalty is age 59 1/2. Roth 401(k)s let you withdraw your money early penalty-free, but only up to the amount you've contributed so far; earnings on your contributions are still subject to the penalty. In some circumstances, money can be withdrawn early from your traditional 401(k) without the 10% penalty -- for example, if you die or become disabled before 59 1/2.
4. Required minimum distributions
While the IRS doesn't mind delaying the taxes on your 401(k) money, it does want to collect its share at some point. Once you hit 70 1/2 you'll have to start taking a certain minimum amount from your 401(k) every year or face a tax penalty of 50% of the amount you failed to withdraw. There's one exception: If you're still working at that age, you can delay taking required minimum distributions (RMDs) from the 401(k) sponsored by your current employer until you retire. If you have retired by age 70 1/2, then you must take your first RMD by April 1 of the year following the year in which you turn 70 1/2. After that, you'll need to take an RMD every year.
Now that you know a bit more about how 401(k)s work, you're ready to squeeze every possible benefit out of yours. For example, if you're fortunate enough to have an employer that makes matching contributions, you'll want to contribute at least enough to your 401(k) to max out the employer match -- those employer contributions are free money just waiting for you to pick up.
And the tax benefits on 401(k) investments mean those accounts are a perfect place to hold any investment that tends to generate a lot of taxes, like REITs (that is, assuming your 401(k) administrator gives you access to such investments; if not, lobbying your HR representative just might get them added to the plan menu). So if you're not already contributing to your 401(k), today's the day to get started.
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