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What is a 401k Plan? – How it Works (for the Utterly Confused!)

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When you signed up for your employer’s 401k plan did you ask yourself: what is a 401k plan?! This was definitely me. I knew that I was supposed to save for retirement and this whole 401k thing was going to take from my pay but that was about it.

 

I remember the lady at the front of the room going on and on about retirement savings but all I heard was womp womp womp. The brochures might as well had been written in a foreign language and … was it lunchtime yet?

 

Yea, it can get pretty boring but when you finally realize just how much is riding on your retirement savings then you begin to perk up really fast. It can literally determine whether you’re enjoying yourself on a lake or passing out smiley face stickers at Wal-Mart because you couldn’t make ends meet. Ouch.

 

So, if you’ve been doing the Birdbox Challenge when it comes to your 401k it’s time to rip off the blindfold and look into the light. Don’t worry, I made it simple for ya’!

 

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What is a 401k plan?

A 401k is a retirement plan offered by some employers. When you sign up for a 401k, your contributions are automatically deducted from your paycheck and deposited into the account.

 

The two most common types of 401ks are:

  • Traditional 401k – A traditional 401k is the most popular of the two. Contributions are made before taxes and your earnings are tax-deferred until retirement.
  • Roth 401k – With a Roth 401k, withdrawals during retirement are not taxed because contributions are made after taxes. Some may opt for this type to avoid federal taxes on their earnings.

 

What’s the point in saving for retirement?

If you’re banking on Social Security alone then you’re playing with fire. Who knows if Social Security will even be an option when you reach retirement age? It’s best to have a plan that includes money that is guaranteed.

 

Each year the cost of living gradually increases due to inflation, so if you’re 30-40 years out from retirement your dollar today will undoubtedly be worth wayyyyy less. Tax rates are sure to be different than they are now and Medicare may be a thing of the past.

 

I don’t say all of this to scare you, but it’s a pretty scary thing to not have any type of retirement savings plan. Without retirement savings, it’s easy to fall into poverty and therefore be unable to afford your basic needs.

 

Could you imagine yourself being old in age, unmarketable to employers, and struggling financially?

 

It’s your future and therefore your responsibility to save for it! Sure, it sucks to save when you could be out enjoying life with the money you’ve earned but literally every dollar you save today makes a huge difference.

 

Other types of retirement accounts

Besides a 401k, other common retirement accounts include:

 

IRA

If you’re saving up to your employer’s match or a 401k isn’t offered, the most popular choice is an IRA. Also known as an Individual Retirement Account, this account comes with tax benefits that were created specifically for retirement.

 

Two types of IRA’s:

  1. Roth IRA: This type is the most popular because of tax-free earnings. There’s no tax deduction for contributions, but you won’t pay taxes on withdrawals made during retirement. You can withdrawal contributions at any time without taxes or penalties because you pay income taxes on the contribution amounts.
  2. Traditional IRA: This type of IRA allows you a tax deduction on contribution amounts but you will pay income taxes on the money that has been withdrawn. Traditional IRAs can be converted to a Roth IRA.

 

When wondering which IRA to choose, ask yourself if you want to pay taxes now (Roth IRA) or later (traditional IRA). Remember that once you reach retirement age it’s likely that your income will be higher than it is now. This means that it may be more beneficial to pay taxes now when your income is lower.

 

403(b) Plan

This retirement plan is offered by public schools and tax-exempt organizations such as churches. A 403(b) plan has similarities to a 401k that include:

  • Tax-deferred earnings
  • A contribution limit of $19,000 (2019)
  • Roth options
  • Must be 59 ½ of age to withdrawal without penalties
  • Employer matching contributions (not required)

 

One major difference is that the $6,000 catch-up contribution for those 50 and older is not allowed with a 403(b) plan.

 

Simplified Employee Pension Plan (SEP)

With a SEP plan, employers make contributions to their employees via traditional IRAs.  Any type of employer, no matter the size can establish this type of retirement plan.

 

SIMPLE IRA Plan

A SIMPLE IRA plan stands for Saving Incentive Match Plan for Employees. A traditional IRA is set up for employees and both employees and employers can make contributions.

 

This plan is more beneficial to small employers with 100 or fewer employees.

 

Additional posts to check out next!

 

 

 

 

 

 

 

 

 

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Are there any 401k contribution limits?

Yes, there’s a contribution limit and yes those types of people who max out their 401k do exist!

 

Contribution limits are subject to annual cost-of-living adjustments and are reviewed by the IRS each year. Your contribution limits may differ from other coworkers depending on your age and salary.

 

For the tax year 2021, the annual contribution limit is $19,500. For participants age 50 and up, an extra $6,500 is allowed for catch-up contributions thus bumping the limit to $26,000.

 

Even if you have multiple 401k accounts, your total contributions to all combined cannot exceed $19,500. Good thing is that contributions made to other accounts, such as IRAs, are not counted in this 401k contribution limit.

 

Compensation limit

If you are a highly compensated employee (HCE), you’re subject to the annual compensation limit which is $290,000 for the year 2021. This means that once your income reaches $290,000 within a calendar year that your employer cannot match any more of your contributions.

 

Plans must pass nondiscrimination tests like the Actual Deferral Percentage (ADP) and the Actual Contribution Percentage in order to remain compliant with IRS rules. This helps prevent high-income earners (HCEs) from receiving an unfair advantage over the non-highly compensated employees.

 

When to start saving for retirement

The answer: As soon as you become available to participate in your employer’s 401k plan. The earlier you begin saving money for retirement, the better. This is because time is your greatest asset.

 

Employees must be allowed to sign up for a retirement plan if both the following requirements are met:

  • 21 years of age.
  • Worked at the company for at least 1 year.

 

Saving earlier means you can reach your goal with smaller investments of money because your contributions have more time to grow. According to Vanguard, a $1 contribution at age 20 could grow to $5.84 by age 65. This, my friends, is the power of compounding.

 

Wtf is compounding?

You may have heard the term “compounding” or “compound interest” buzzing around. To sum it up, it is when you earn interest from the interest earned on the money you’ve invested.

 

For example, let’s say you invest $2,000 and earn 5% per year. This means you will earn $100 in the first year, making your balance $2,100. In the second year, you will earn $105 ($2,000 original investment + $100 earning + $5 earning from interest earned the previous year). By the third year, you will earn $105.25 and so on.

 

Can you see now why time is your greatest asset? The more time that goes by the more powerful compounding becomes!

 

The longer you wait to save for retirement, the more you will need to save each year so it’s beneficial to start right now rather than waiting until that perfect time that will probably never come.

 

Well, what if I didn’t save in my early 20s?

Saving for retirement early is ideal, but you’re not totally up sh$# creek if you missed your early 20s. While it’s true that you will have to save more than if you had started earlier, it’s still possible to reach your targeted goal before you tell your employer peace out.

 

Make the maximum contribution. Remember, for 2021 this is $19,500. As your pay increases from raises and promotions, take your extra earnings and use them as retirement contributions.

 

Pay down debt. High-interest debts, such as credit card debt, make it difficult for anyone to find spare money to apply to other financial goals.

By tackling your debt, your spendable income increases thus giving you more money to apply to your retirement plans.

Have no clue where to start when it comes to paying off debt? Take my free debt payoff course where I go into the strategies that allowed me to become debt free on a single income!

 

Don’t take on extra expenses. Ah yes, lifestyle creep. As our pay increases, it’s common for our expenses to increase as well. Suddenly we need a new car to match our new job position and whatnot. Unfortunately, what we see as “extra money” is no longer extra because we’re using it to pay for a new expense.

As your income grows, keep your expenses relatively the same in order to have more money to apply to your retirement savings.

 

Open an IRA. If you’re saving up to the maximum contribution, open an IRA! This way, you can save an additional $6,000 if you’re under age 50 or $7,000 if you’re 50 and up. Earnings grow tax-free which can really help you make up for lost time.

Unfortunately, IRAs do have income limits in which you are not eligible if your modified adjusted gross income is over a certain amount.

 

For 2021 the income limits are:

  • $140,000 if filing as a single individual.
  • $208,000 if married and filing joint returns.
  • $10,000 if married but filing separately.

 

How much you should be saving

The answer is not so cut and dry. There are a lot of factors that come into play such as:

  • The lifestyle you wish to have during retirement
  • Other sources of income you expect to have
  • When you plan to retire

 

But, to keep it simple: What you can afford! You’re living in the now, so don’t put yourself out on the streets trying to live it up in the next 30-40 years.

 

To get a bit more technical, aim to save enough to get the full employer match. Per Vanguard, you should save at least 12-15 percent of your pay (+employer contributions) each year.

 

Of course, that’s not possible for everyone, but increasing your savings rate by 1% each year can help you painlessly reach the recommended 12-15 percent. Some plans offer an automatic savings increase, in which your contribution rate is increased for you each year.

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What is a 401k plan employer match?

An employer match is when an employer matches a certain percentage of your contributions. The amount differs, but is typically a 50-100 percent match!

 

As an example, let’s say your employer matches 50% of your contributions up to 6% of your gross salary. This means that for every dollar you save, your employer adds 50 cents to match your savings. So your dollar is actually worth $1.50.

 

Basically, this is free money that you should be taking advantage of!

 

What happens to my 401k if I leave my job?

Rest assured that when you leave your job, your 401k contributions will not vanish into thin air. In fact, you have multiple options. You can:

Roll your 401k into an IRA – Choosing this option gives you access to new investment options.

 

Leave your money in the plan – If you have more than $5,000, you can typically leave your money in the plan. Your investments will stay the same but you will no longer be able to contribute any more money.

 

Roll over the money to your current employer’s plan – If your employer allows rollovers, you can add your previous contributions to your new plan.

It may sound tempting to withdraw your money when you leave your employer, but you will have to pay taxes and penalties. Withdrawals made before age 59 ½ are subject to a 10% penalty in addition to taxes. This means that you won’t get the full amount and years of saving could be flushed down the drain.

 

Do I have to withdraw from my 401k?

Using other sources of income to live off of while your retirement contributions continue to grow tax-free sounds like a dream right? Yea, it sounded great to me too until I learned that wasn’t really possible.

 

Unfortunately, once you reach age 70 ½ you have to start making withdrawals otherwise you’ll be facing a tax penalty of 50% of the amount you should have withdrawn.

 

There’s an amount called the required minimum distribution or “RMD,” which is the minimum you must withdraw from your plan. Even if you make withdrawals, if it doesn’t satisfy your RMD then you will need to take out extra money.

 

You do not have to spend the excess cash, but it needs to be removed from your plan in order to avoid getting penalized.

 

Switch to Blooom!

Blooom is made up of a group of experts that dedicate their time to managing your 401k online. They monitor your investments for you and make changes as you near retirement age.

 

They pride themselves on being affordable and save you money by making choices based on fund cost. Start with a free 401k analysis to see if making the switch to Blooom is the right move for you!

 

Closing

A 401k plan isn’t the most exciting topic of discussion, especially if you’re young, but understanding how it works can help you maximize your retirement options. Start contributing what you can right now, take advantage of your employer match, and watch your savings grow!

 

You’ll thank yourself later.

  1. Thanks Dyana. I’d also like to mention to people who are reading from this article and trying to decide between a Roth and a Regular 401(k), they should only choose the Roth if they are in the lowest income bracket (making less than $23,000). Otherwise they should choose the Regular 401(k).
    Here’s the math and analysis of that conclusion.
    https://wantfi.com/skip-the-roth-401k.html

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