If you’ve ever heard someone talk about their 401(k) in a social setting and you’ve just nodded and smiled like you knew what they were talking about but actually didn’t, we’re here to clear up the confusion. Essentially, a 401(k) is an investment—but in colloquial terms, it’s a factor showing you have your sh*t together like a BAUCE and are on top of your adult game.
What is a 401(k)?
A 401(k) is a savings plan that allows employees to take a portion of their paycheck and invest it in that plan before taxes are taken out of it. So on pay-day, instead of immediately receiving all your money earned, a portion of your paycheck is already taken out and invested immediately in your 401(k).
Is it taxed?
It’s untaxed until retirement, where withdrawals are then taxed as income. It’s also subject to 10% tax if you try to withdraw while you’re under the age of 59 ½ (why ½, we don’t know).
Why is it called a 401(k)?
It’s literally the section of the tax code regarding this plan—401(k).
You, through your paychecks (salary), and your employer’s contributions. Most employers match an employee’s contribution to the plan.
Are there different types of 401(k) plans?
Yep! There are several types of 401(k) plans available to employers—traditional 401(k) plans, safe harbor plans, and SIMPLE Plans. We’ll break it down in a few words or less:
- Traditional 401(k): The employee contributes tax-deferred earnings to their 401(k) plan. Taxes are paid on these contributions when the savings are withdrawn. To benefit their employees, some employers match a portion of an employee’s 401(k) contributions. This type of plan is usually found in large companies.
- Safe Harbor 401(k): Employer contributions are non-forfeitable (cannot be taken away from you) and fully vested when made. Employers can even make contributions for eligible employees who choose not to personally contribute to their 401(k). Note, however that the employer contribution cannot exceed 5% of the employee’s compensation.
- SIMPLE 401(k): Employers with less than 100 employees typically have this plan available. Employees contribute to their retirement savings out of their pay, but the maximum amount allowed is $11,500 per ear. Employers can also make contributions (up to 3%) to their employees’ accounts.
For the rules behind other plans, you can hop over to the IRS.
Is there a limit to how much money from my paycheck I can put in a 401(k) plan?
In 2015 and 2016 the federal limit is $18,000 for the 2015 tax year, but anyone 50 years or older may contribute an additional $6,000. The $18,000 may be increased in future years for cost-of-living adjustments.
DO’s and DON’T’s:
DO start early. A 401(k) basically means free money, since you get an immediate tax break, a possible matching contribution from your employer, and tax-deferred growth, which mans you don’t pay taxes each year on distributions.
DO your research. Talk to or hire a financial planner, and find out what kind of plan your company has for 401(k). Know which plan works for you, and know the penalties for certain kinds of actions.
DO save at least 10%. It sounds like a lot, but it’s an investment for your future.
DON’T freak out. There’s a lot of financial jargon involved with 401(k), but it’s not that bad. Again, talk to a financial planner and know that you’re saving for your retirement.
DON’T forget to withdraw when you’re 70. You need to withdraw money from this account by April 1st of the year after you turn 70 and ½. The amount you withdraw is known as the required minimum distribution, or RMD. Failing to take out the RMD subjects your account to a tax penalty. Yikes!
DO think about your future. In order to be a self-made success, you have to think about achieving a financial status that is long-winded, not short-termed. Learning about 401(k)s is your first venture into investment territory and building wealth, so be sure to start contributing money to one at least by your late twenties. Trust me, your 65 year-old badass self will love you for it.