Posted by Ashley Zoerner on
Working for a company that offers a 401K option is a huge benefit for employees. However, some employees aren’t sure exactly what a 401K even is or how it works. Sure, they may contribute each payday, but the ins and outs are a mystery. In this post, we’ll discuss all things 401K including the benefits of having one and how to maximize its potential.
A 401K is basically a company-sponsored retirement account that employees can choose to contribute to. Usually, this account grows via automatic payments from a worker's paycheck and is matched to some degree by the employer. The amount of time you must be employed to be eligible for this benefit varies, with 68% of plans allowing a contribution with your first paycheck and 24% requiring a year of employment beforehand.
There are two types of 401K plans, traditional and Roth. They are similar except for how each is taxed. With a traditional plan, you are not taxed on the money you put into your 401K each year, but you will be taxed when you make a withdrawal down the line. A Roth 401K is the opposite: you are taxed on the contributions you put in at the beginning, but your withdrawals later on will be tax-free. Assuming your employer offers both programs, determining which one is best for you may boil down to whether you can afford to pay taxes on your contribution now or later.
While joining your company’s 401K plan is totally up to you, there are plenty of reasons why you should. First off, it’s an easy way to save money. That’s because your employer automatically deducts your contribution from each paycheck which means you don’t have to consciously decide to put it aside. Also, it’s income that you don’t see, so most likely you won’t miss it. Best of all, the money you accrue is yours, even if you change jobs.
Next, most employers offer some sort of matching contribution, which generally varies from 1-10% of your paycheck. For example, if your company matched up to 5% on your 401K, and you decide to contribute 5% of your paycheck, you’ll actually receive a total of 10% of your paycheck toward your 401K. That’s essentially free money that you wouldn’t get if you did not participate in the program. Finally, the funds in your 401K can be used when you need it most, like in the case of an emergency or hardship.
Most 401Ks require that you wait until you are 59 ½ years of age before you can withdraw from your account. Withdrawing money out early may lead to fees of up to 10% of the withdrawal amount, so it’s recommended to speak to a financial advisor to explore all your options before doing so. The purpose of your 401K is to be there when you retire to help support you with a steady income. Having this cushion will ensure that this phase of your life is much more enjoyable and stress-free.
Sometimes, it makes sense to borrow from your 401K before it’s time to retire. This is a personal decision that should not be taken lightly. There are multiple ways to go about this. The first, and most popular, is to make an early withdrawal from your 401K, which will incur the 10% withdrawal fee. Another way is to see if you may qualify for a hardship withdrawal, which does not require you to pay the money back, has no limit on the amount you can take out, and doesn’t come with penalties. According to the IRS, a hardship is defined as “an immediate and heavy financial need of the employee,” and includes circumstances such as certain medical expenses, some costs for buying a home, funeral and burial expenses, or education expenses. Withdrawing from your 401K for a down payment on a home may seem like a great idea, but not all employers allow early withdrawals. There is also a possibility that you can withdraw from a plan that you had with a previous employer, but you will likely incur that 10% penalty on the amount withdrawn.
Another option is borrowing from your 401K with a loan, which depends on your employer and whether it’s something they offer. There are drawbacks to going this route, including a limit on what you can take out and the possibility of having to pay additional taxes on the amount you borrow. Because this is a loan, you’ll have to repay within a certain timeframe which becomes shorter if you leave your job during that time. The IRS limits these types of loans to 50% of your vested account balance or $50,000, whichever is less. 401K loan payments need to be made at least quarterly and include principal and interest that is required to be paid in full within five years.
Deciding on opening a 401K with your employer and whether to tap into it before retirement comes with a lot of considerations. Being informed is your best tool in making the right decision. Speaking with some in human resources at your company, hiring a financial advisor to help manage your money, and working with the right mortgage lender when it’s time to secure financing for homeownership are all key in making a safe and sound decision regarding your 401K.