Working for a company that offers a 401(k) option is a huge benefit for employees. However, some employees aren’t sure exactly what a 401(k) 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 the basics of a 401(k), the benefits of having one, and how to utilize it for different needs you may have.  Certain uses have tax implications, so you should always consult a tax adviser for tax advice.  

A 401(k) 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 main types of 401(k) 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 401(k) each year, but you will be taxed when you make a qualified withdrawal down the line. A Roth 401(k) is the opposite: you are taxed on the contributions you put in at the beginning, but your qualified withdrawals later on will not be taxed. 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 401(k) 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 contribute is yours, even if you change jobs. 

Next, most employers offer some sort of matching contribution, which generally varies from 1% or more of your paycheck. For example, if your company matched up to 5% on your 401(k), and you decide to contribute 5% of your paycheck, you’ll actually receive a total of 10% of your paycheck toward your 401(k). That’s an extra benefit that you wouldn’t get if you did not participate in the program. Finally, the funds in your 401(k) can be used when you need it most, like in the case of an emergency or hardship; as discussed below, this is subject to certain restrictions, however.  

Most 401(k)’s 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 a tax penalty 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 401(k) is to be there when you retire to help support you with a steady income. Having this cushion can help ensure that this phase of your life is much more enjoyable and stress-free.  

Sometimes, it makes sense to withdraw funds from your 401(k) 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 is to make an early withdrawal from your 401(k), which will incur the 10% withdrawal tax penalty. Another way is to see if you may qualify for a hardship withdrawal, which may allow you to avoid the early withdrawal penalty; however, this is determined on a case by case basis and you should therefore consider consulting an advisor. 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 401(k) 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 401(k) with a loan, which depends on your employer’s plan 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. Usually, these types of loans are limited to 50% of your vested account balance or $50,000, whichever is less; 401(k) loan repayments need to be made at least quarterly and include principal and interest that is required to be paid in full within five years. Be sure to consult an advisor if you interested in this option as borrowing from your 401(k) can have a negative effect on your account and your retirement. 

Deciding on opening a 401(k) 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 someone in human resources at your company, hiring a financial advisor to help manage your money, consulting a tax professional, 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 401(k).