When planning for your future, take time to think about when you’ll retire. More specifically, how will you be able to afford retirement?
To retire, you have to save enough money to fund your lifestyle without working. But figuring out how much to save can seem complicated. Although the exact amount will vary from person to person, a good rule of thumb is to save 10 times your annual income by age 67.1
Saving that much can seem daunting, but there are many tools to help you get there. One of the best ways to save for retirement and build wealth over time is with a 401(k) plan.
What is a 401(k) plan?
A 401(k) is a tax-advantaged retirement savings plan sponsored by an employer that allows you to grow your money over time to ensure you can retain your comfortable lifestyle during retirement. This type of account allows you to save and invest a portion of your pre-tax income. A 401(k) offers additional tax benefits, like decreasing your taxable income and lowering the income tax you’ll pay each year.
Since 401(k) contributions are tax-deferred, you can deduct the amount you contribute from your income each year, thus lowering your taxable income. However, you will have to pay taxes on the money once you retire and start withdrawing it.
Only an employer can offer a 401(k) – and it’s not a savings account. The money you put into your 401(k) is not quickly accessible. It’s meant to grow over time to serve you in retirement. You can’t easily withdraw money like you could with a traditional savings account.
How does a 401(k) plan work?
Contributing to a 401(k) plan is simple: You opt in if your employer offers a 401(k) option. This may involve filling out some initial paperwork.
From there, you can choose how much of your paycheck you want to contribute. Some employers even offer to match your contributions – this is a helpful option because it’s just like getting free money.
For example, your employer may offer to match every dollar you contribute to your 401(k) up to 5% of your gross pay for the year. If your salary is $60,000, your employer can contribute up to $3,000 to your 401(k) per tax year.
401(k) contributions: How do they work?
After recognizing the importance of a 401(k) plan, your next question may be, “How much should I contribute year after year?” An equally important question is, “How much can I contribute?” A 401(k) has a contribution limit set by the Internal Revenue Service (IRS), which means you can’t just add as much money as you like.
For the 2023 tax year, the maximum 401(k) contribution limit for anyone under 50 is $22,500.2 If you’re 50 or older, the IRS allows catch-up contributions of $7,500 per year on top of the regular contribution limit.2 This is subject to change in any given year, so research each year’s contribution limits at the beginning of the calendar year to see if there are any changes.
When deciding how much to contribute to a 401(k), consider when you want to retire and how much you’ll need to live on each year.
To save 10 times your income by age 67, you’ll need to save around 15% each year starting in your mid-20s.1 This 15% savings rate may sound high, but it includes 401(k) contributions, an employer match, cash savings, and debt repayment. Remember: You can adjust your 401(k) contributions depending on your age and current situation.
If you can’t afford to max out your retirement account each year, you can still aim to contribute enough to get your employer match if it’s offered. This is (practically) free money that you don’t want to leave on the table. Assess your situation every six to 12 months to see if you can increase your contributions over time.
What does it mean to be vested in your 401(k) retirement plan?
The term “vesting” means ownership. It refers to the amount of money in your 401(k) that is yours to keep, whether you stay with your employer or move to another job.
The IRS explains that being 100% vested means you own your entire 401(k) balance, and it can’t be forfeited or taken back by your employer for any reason.3
Some employers don’t immediately give you complete ownership of your 401(k) match dollars. For example, your employer may require you to be on the job for several years before you can be 100% vested in your 401(k) balance.
If you leave your employer before that mark, you could lose some or all employer contributions. However, any contributions made by you, the employee, are yours to keep and cannot be taken away from you.
Quitting your job? 4 options for your 401(k)
Since a 401(k) is tied to your employer, take the time to know what to do when you leave your job. There are several options:
1. Switch your 401(k) into an IRA
When you leave your job, you can switch your 401(k) to an individual retirement account (IRA). A brokerage firm, bank, or mutual fund company would manage the IRA. A financial advisor can also help you manage an IRA.
The benefit of moving your money to an IRA is that you will still have your money in a tax-advantaged account. An IRA can also offer more investment options than an employer-sponsored 401(k).
2. Withdraw your money
It’s possible to withdraw the money from your 401(k) when you quit your job, but in most cases it would hurt you. Making a withdrawal before 59 ½ can result in a steep 10% penalty.4
While some exceptions allow you to avoid the penalty, they are few and far between. Unless you have an emergency and need money, keeping it in a retirement account is best.
3. Move the 401(k) plan to a new employer
If you’re leaving your job for a new one, see whether you can roll your existing 401(k) into your new one. This allows you to keep the money in a tax-advantaged account, reducing your tax burden.
Merging your 401(k) accounts keeps your retirement savings in one place, making tracking easier.
4. Leave the 401(k) plan with the former employer
The final option is to leave your 401(k) plan with your former employer. This can be a good option if you like the investment options offered, and it is also the option with the least hassle.
However, if you switch jobs multiple times over your career and leave each 401(k) plan with different employers, you risk losing track of your retirement savings.
Generally, you’ll want to wait until 59½ to withdraw money from your 401(k). Why? Because if you withdraw money before that age, you may face a 10% early withdrawal penalty from the IRS.4 This means you may have to pay taxes on any amounts you cash out (since you contributed pre-tax dollars).
The withdrawal penalty applies even in different situations, like moving to another country. In this scenario, your options would be the same as if you were leaving your job, and choosing to withdraw the money early would result in a penalty.
However, there are some cases where you can avoid the penalty fee. The following are some of these situations.5
- Withdrawing funds as a down payment on your first home purchase
- Unreimbursed medical expenses that exceed a certain percentage of your adjusted gross income
- Education expenses that fall under a “hardship withdrawal”
Avoid early withdrawals to avoid any chance of receiving a penalty.
Learn more about the pros and cons of cashing out your 401(k) before retirement.
Other private retirement alternatives
A 401(k) plan isn’t your only option when it comes to retirement plans. There are other private retirement accounts to consider instead of – or in addition to – a 401(k).
A Roth 401(k) is similar to a traditional 401(k) – except that your account is funded with after-tax dollars rather than pre-tax dollars. You pay taxes on your income before contributing to your retirement plan and make tax-free withdrawals during your retirement years.
If you expect your tax rate at retirement to be higher than when you are making contributions, a Roth 401(k) is worth considering. Since you pay taxes on your contributions upfront, you don’t have to worry about a higher tax rate upon retirement taking away too much of your savings.
You might have heard of it as a retirement savings option, but what is an IRA, exactly? IRA stands for individual retirement account. There are two main types: traditional IRAs and Roth IRAs. A traditional IRA is funded with pre-tax dollars, while a Roth IRA is funded with money that has been taxed. The main difference is whether you’ll pay taxes when you contribute (Roth IRA) or retire (traditional IRA).
Regardless of which option you choose, an IRA can be used as a separate, alternative retirement savings tool, or it can be used in addition to your 401(k) plan.
The annual contribution limit for an IRA is $6,500 if you’re under 50 and $7,500 if you’re over 50.2 There are also income limits to be eligible to contribute to an IRA.
Start planning your retirement today
A 401(k) plan is a helpful retirement tool to help you save money to retire comfortably. It offers several advantages, including free money if your employer offers a match and the ability to save pre-tax money for retirement, which decreases your total taxable income.6
If you are offered an employer match, plan on contributing enough to get the full match and be mindful of vesting rules. While you might not be able to contribute much to your 401(k) when you first begin your career, you’ll hopefully increase your contributions as you advance and grow your income.
Learn how to plan for retirement in your 20s and 30s to help maximize your savings.