A 401(k) is a qualified retirement plan that employers can sponsor for eligible employees to save and invest for their own retirement on a tax-deferred basis. With a 401k plan, employees can dedicate a percentage of their pre-tax salary to invest in a range of vehicles like stocks, bond, and mutual funds.
A sponsor is a company, employer, or professional group or union that sets up a 401(k) as a retirement plan for its employees or members. As a 401(k) sponsor, the company develops the plan’s investment options and guidelines for membership, or “vesting.” The employer sponsor may also decide to contribute to its employees’ 401(k)s with cash and stocks.
Your sponsor will provide at least three diversified investment options. Deciding which is right for you will depend on your age, risk tolerance, goals and expectations.
Some employers match their employees’ contributions up to a certain percentage. This is free, tax-deferred money from your employer, and you’ll get it by contributing the minimum your employer requires.
Here’s an example of the difference an employer contribution can make to your 401(k):
If you earn $50,000 a year and contribute 6% into your 401(k), you will have added $3,000 in your first year. If your employer matches your contribution dollar for dollar, you would have $6,000. Let’s say your employer contributes 50 cents for every dollar you do. You would still be ending the year with $4,500 more in your 401(k). In short, make sure you contribute at least enough to secure your employer’s contribution.
There are limits to how much you can contribute to your 401(k). These limits can change annually, and people over 50 can contribute more. Here’s what the 2020 limits are:
The laws, rules and regulations depend on what kind of 401(k) you have. There are traditional, safe harbor and SIMPLE 401(k) plans. Each has different rules that must be followed. According to the IRS, “To qualify for the tax benefits available to qualified plans, a plan must both contain language that meets certain requirements (qualification rules) of the tax law and be operated in accordance with the plan’s provisions.”
With a Roth 401(k) you pay taxes on the money before you deposit it to the account, not when you take disbursements. Funds in traditional 401(k)s are deposited pre-tax and will be taxed when you start withdrawing money.
Both have benefits depending on the account holder’s age, tax exposure and future outlook. These account types can be used simultaneously to limit tax exposure and balance risk and long- and short-term benefits.
To see how much you need to invest to prepare for your retirement, use KeyBank’s savings calculator.
The best course of action is to wait until you retire to withdraw money from your 401(k). If you need to access the money before that, you can trigger taxes and fees. Here’s what to know:
For more tips, investment and retirement strategies visit our Financial Wellness section.