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401(k) Basics: Everything You Need to Know

Updated: Feb. 16, 2021, 1:46 p.m.

What is a 401(k) Plan?

A 401(k) is a tax-advantaged retirement account, usually offered through an employer. Employees may elect to defer a certain percentage of their paychecks to their 401(k)s, and employers often match some of these contributions.

The various types of 401(k)s differ in eligibility requirements and how they are taxed. Here's everything you need to know if you're thinking about contributing to a 401(k).

Benefits of a 401(k)

Placing your savings in a 401(k) confers many advantages. Here are some of the most important ones:

  • Tax savings: Contributions to traditional 401(k)s are made with pre-tax dollars, which reduces your taxable income for the current year. The contributions are tax-deferred, which means that you instead owe taxes when you withdraw funds in retirement. If you are in a higher tax bracket today than you expect to be in retirement, then deferring the tax liability can save you money.
  • High contribution limits: 401(k) contribution limits are much higher than contribution limits for Individual Retirement Account (IRAs).
  • Employer match: Employers often match a percentage of their employees' contributions. This is like getting a bonus and reduces how much you need to save for retirement on your own.
  • Automatic contributions: You can elect to defer a percentage of each paycheck to your 401(k), so that you don't have to make retirement contributions manually. You can also change your contribution percentage at any time.
  • Rollovers: If you leave your employer, you may keep your retirement savings in your old 401(k) or roll over the funds into your new company's 401(k) or an IRA.

401(k)s are company-sponsored retirement plans, so as soon as you meet your company's eligibility requirements, you may enroll and decide how much of each paycheck you would like to contribute. Some companies automatically enroll employees in their 401(k) plans. Check with your company's HR department to learn more about your plan.

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What are 401(k) limits?

These are some of the key 401(k) rules and limits of which you should be aware if you plan to contribute to this type of account.

Contribution limits

You may contribute up to $19,500 to a 401(k) in 2020 and 2021, unless you are age 50 or older, in which case you may make an extra catch-up contribution of up to $6,500. These contribution limits can change yearly.

Income limits

People classified by the IRS as highly compensated employees (HCEs) -- those who own more than 5% of the company for which they work or earn more than $130,000 annually in 2020 and 2021 -- may not be eligible to contribute to their 401(k)s up to the maximum limits.

Learn the 401(k) rules for highly compensated employees

401(k) withdrawal rules

Here’s a closer look at some of the rules that apply to 401(k) withdrawals.

Distributions

You may take money out of your 401(k) at any time, but you will pay a 10% early withdrawal penalty if you do so before age 59 1/2, unless you have a qualifying exception. Qualifying exceptions include large medical expenses, educational expenses, and first-home purchases, among others.

Required minimum distributions

Required minimum distributions (RMDs) are mandatory distributions from 401(k)s that must begin when you turn 72. Before 2020, RMDs were required to begin at age 70 1/2. Calculate your RMD by dividing your 401(k) balance by the distribution period next to your age in this table. Failure to annually withdraw at least this much triggers a 50% penalty on the amount that you should have withdrawn.

Adults ages 72 and older who are still working may delay RMDs from their current 401(k) until they retire, though if they have any IRAs or old 401(k)s from former employers, they must still take their RMDs from these accounts starting at age 72.

Rule of 55

The Rule of 55 permits those who quit their jobs or are fired in the year they turn 55 or later to take penalty-free withdrawals from their 401(k)s even if they are younger than 59 1/2. Public safety workers are eligible for penalty-free distributions if they leave their jobs after they turn 50. You may take penalty-free distributions only from your most recent 401(k), not from other retirement accounts.

401(k) loan

Some 401(k)s enable participants to borrow money from their plans and pay it back over time with interest. A 401(k) loan can for some people be a nice alternative to a traditional bank loan, but withdrawing funds could slow the growth of your retirement savings. If you are unable to pay back the full amount that you borrowed by the end of the loan term, the outstanding balance is considered a distribution and taxed accordingly.

Different types of 401(k)s

While the traditional 401(k)s is most common, there are a few other kinds of 401(k)s:

Roth 401(k) This is much the same as a traditional 401(k), except that contributions are made with after-tax dollars. Contributions to Roth 401(k)s don't reduce your taxable income for the current year, but rather are distributed tax-free in retirement.
Solo 401(k) A solo 401(k) is available only to self-employed people. This type of 401(k) effectively has higher annual contribution limits because you can contribute as both employee and employer.

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