How a 401(k) works

When you participate in your employer's 401(k) plan, you choose the percentage of your income that you want to contribute from each paycheck before any taxes are taken out.

During 2019, you can put contribute up to $19,000 from your pre-tax pay if you're under 50. If you're 50 or older, you can put in as much as $25,000. The extra $6,000 "catch-up contribution" is meant to help boost your retirement savings when you're coming down to the wire.

Making it your goal to contribute the max each year will put you on a path toward having enough savings for a comfortable retirement.

A 401(k) gives you a break on taxes because you don't pay tax on your contributions or your investment earnings until you make withdrawals in retirement — when you're likely to be in a lower tax bracket.

There's a strong incentive to keep you from touching your 401(k) money too soon. If you make a withdrawal before you reach age 59 1/2, you'll usually owe a 10% penalty plus income tax on the amount taken out.

The laws offer a few exceptions. For example, you can make penalty-free withdrawals if you become permanently disabled, or if you need to pay off a medical bill that tops 10% of your adjusted gross income.

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The 401(k) employer match

Here's more about the free money from the boss: Some employers match workers' 401(k) contributions, up to a certain percentage of their salaries. The average employer match is now a record 4.7%, according to Fidelity Investments.

When your employer matches, you want to try contributing at least the percentage of your pay that will be matched. If the match is 5% where you work, you want to be sure that at least 5% of your salary is going into your 401(k).

Many companies match dollar for dollar up to the threshold, though many others give just 50 cents for each $1 a worker contributes.

Let's say your employer is one of the more generous ones and fully matches every dollar, up to 6% of your pay.

If you earn $60,000 a year and contribute 10% to your 401(k), you're putting $6,000 into your account annually. The company matches you up to 6% of your $60,000 salary, meaning it contributes $3,600 — a great perk.

An employer matching 50 cents on the dollar under that same scenario would contribute half as much: $1,800.

How your 401(k) money is invested

Workers typically have a variety of investments to choose from within their 401(k)s. These might include index funds, other mutual funds, individual stocks and bonds, maybe even company stock.

You choose the risk level for your portfolio, based on your time horizon for investing, your goals, assets, and the other retirement savings that you might have.

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As you draw closer to retirement, you'll want to readjust your portfolio to make it more conservative, so you can preserve as much of your savings as possible.

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401(k) rollovers and RMDs

So, what if you have a 401(k) and you decide it's time to change jobs? You can:

  • Leave your 401(k) right where it is, at your old company.
  • Roll it over into a 401(k) at your new job.
  • Roll it over into an IRA, or individual retirement account. An IRA is similar to a 401(k) in many ways, though it's not tied to an employer.

Rolling over your 401(k) can be a good idea because that will make it easier for you to keep track of your retirement savings. You might forget about a 401(k) left behind at a previous job. (Seriously, it happens.)

A rollover is a direct transfer of funds from one retirement plan to another — it's not a withdrawal. So there are no penalties, fees or taxes to worry about.

Once you reach age 70 1/2, 401(k) withdrawals become mandatory. When you don't take your annual "required minimum distributions" (RMDs), you face a stiff tax penalty equal to 50% of the amount that should have been withdrawn.

What's a Roth 401(k)?

A 401(k) cuts your tax bill now and pushes those taxes down the road, to your retirement years. That strategy makes sense if believe your income will be lower in retirement.

But if you think it's likely you'll have a higher income in retirement, a Roth 401(k) might be a smarter choice than the usual garden-variety 401(k). You'll want to see if your company offers the Roth option, which switches the taxes around.

With a Roth 401(k), you contribute a portion of your pay after taxes have been taken out, not before. When you retire, you pay no taxes on your withdrawals — including your investment earnings.

Pensions vs. 401(k) plans

The 401(k) plan gets its odd name from the section of the tax code that helped create the accounts in the 1980s. Companies saw an opportunity to offer their employees tax-advantaged savings accounts that were less expensive than pensions.

Pension plans used to be fairly common. When a company has a pension, it invests money on behalf of its employees so it can provide them with income in retirement.

In 1998, 59% of Fortune 500 companies were offering their employees pension plans, but by 2017 just 16% were, according to a report from consulting firm Willis Towers Watson.

Pensions offer set amounts of money that retirees can count on (unless the employer goes belly-up). With 401(k) plans, what you receive depends on your contributions and the performance of your portfolio.

But a 401(k) gives you more control over your retirement savings. Contributing to a 401(k) plan through your job can be a good way to painlessly put money aside for your later years, save on taxes, and get a little bit more from the boss.

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About the Author

Doug Whiteman

Doug Whiteman

Former Editor-in-Chief

Doug Whiteman was formerly the editor-in-chief of MoneyWise. He has been quoted by The Wall Street Journal, USA Today and CNBC.com and has been interviewed on Fox Business, CBS Radio and the syndicated TV show "First Business."

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