Iowa is known for many things, including corn and pork production, political caucuses, and the Iowa State Fair. But retirement planning? Not so much. Here’s why you need to pay attention to your 401(k) and why it is one of the best options you have to save for retirement.
If you are a pre-retiree still in the workforce, you may have heard of a 401(k) plan. Many companies offer retirement plans to their employees as part of their benefits package, the most common being a 401(k). There are multiple reasons to participate in 401(k) plans, such as tax advantages to employer matching and more. But before you start contributing to your employer’s 401(k) plan, it’s important to fully understand how it works and the rules surrounding it. Continue reading to learn more about what a 401(k) is, how it works, the benefits, and key rules.
What is a 401(k)?
A 401(k) is an employer-sponsored retirement savings plan that allows employees to contribute a portion of their salary into a long-term investment account through regular, automatic paycheck deductions. Additionally, 401(k)s give employees tax breaks on the money they contribute. Depending on the type of plan you have, the tax break comes either immediately when you contribute the money, or later when you withdraw in retirement.
Types of 401(k) Plans
There are two main types of 401(k) plans – traditional and Roth. With a traditional plan, employee contributions are deducted from gross income, which means the money comes from the employee’s payroll before taxes have been deducted. As a result, the employee’s taxable income is reduced by the total amount of contributions for the year and can be reported as a tax deduction for that tax year. No taxes are due on the money contributed or the investment earnings until the employee withdrawals the money, usually in retirement.
With a Roth 401(k), contributions are deducted from the employee’s after-tax income, meaning contributions come from the employee’s pay after taxes have been deducted. As a result, there are no tax deductions in the same year of the contribution. When the money is withdrawn during retirement, no additional taxes are due on the contribution or the investment earnings.
What are the benefits?
The obvious benefit of starting a 401(k) is you are saving money for yourself later in life. It’s one of the easiest ways to save money because it never touches your actual bank account until you withdraw. Another significant benefit is that many employers offer to match a portion of what you save, meaning you can help boost your retirement savings even more. In addition, a 401(k) can help reduce the amount of income tax the employee owes, since contributions are made on a pre-tax basis. 401(k) earnings also grow tax-deferred. Lastly, 401(k)s often have lower fees and expenses than other investment accounts.
What Happens if You Move Jobs?
When you leave a company, you generally have four options when it comes to your 401(k).
- Withdraw the money
This is generally not a good decision unless you’re in urgent need of the cash. The money will be taxed the same year it’s withdrawn and you will be hit with the additional 10% early distribution tax, unless you’re over 59½, permanently disabled, or meet the other IRS criteria for an exemption.
- Roll it over into an IRA
By moving the money into an IRA you can help avoid immediate taxes and maintain the account’s tax-advantage status. Additionally, you’ll be able to select a wider range of investment choices than with your employer’s plan.
- Leave it with your old employer
Sometimes, employers will allow a departing employee to keep a 401(k) account in their old plan indefinitely, though the employee can no longer make contributions to it. Though in the case of smaller accounts, less than $5,000, the employer may force the employee to move the money elsewhere. Leaving your 401(k) with an old employer only makes sense if the plan is well managed and you’re happy with the investment choices it offers.
- Move it to your new employer
You can usually move your 401(k) balance to your new employer’s plan. This maintains the account’s tax-deferred status, avoiding immediate taxes.
Contribution Limits
The maximum amount that an employee or employer can contribute to a 401(k) plan is adjusted periodically to account for inflation. This year, the annual limit on employee contributions is $20,500 per year for employees under 50 years of age. Those 50 and over can make an additional $6,500 contribution.
If the employer also contributes, there is a total employee-and-employer contribution amount for the year. In 2022, for employees under 50, the total cannot exceed $61,000 and for those over 50, the limit is $67,500.
Required Minimum Distributions (RMDs)
Traditional 401(k) account holders are subject to required minimum distributions (RMDs) after reaching age 72. An RMD is an IRS-mandated amount of money that must be withdrawn from a traditional IRA or an employer-sponsored retirement account each year. RMDs are calculated by dividing prior year-end account balances by a life expectancy factor in the IRS Uniform Lifetime Table.
Final Thoughts
It’s never too early to start saving for retirement. Contributing to your employer’s 401(k) plan is a simple and hassle-free way to get started and enjoy the peace of mind that comes with knowing you’re preparing for your future. If you’re young, it’s okay to start with even just a small contribution. It will add up over time and you can increase the contribution as you start to earn more.
At Johnson Wealth & Income Management, we have helped many Iowans, of all ages, find the path to the retirement they’ve always dreamt of. If you are looking for an Iowa-based, full-service financial firm you can count on, contact the team at Johnson Wealth and Income Management here today.
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