401(k)s: A Student’s Primer

retirement and 401k

A 401(k) is a retirement plan offered by your employer that allows you to invest money in mutual funds. Generally, these funds favor “safe” investments like Treasury bonds or money markets. 401(k)s are this century’s alternative to pensions, and put the onus of saving on you, the worker, rather than the company.

The main difference between a 401(k) and an IRA is that a 401(k) is offered by your employer, while you maintain an IRA independent of where you work. An IRA offers more flexibility, but 401(k)s are somewhat easier to manage.

Come payday, an employee is allowed to deposit part of his earnings into a company-approved 401(k) account, and many companies choose to match some or all of the contribution. Companies usually offer a variety of accounts that give different weights to stocks, bonds, money markets and the company’s own stock. As a rule, stock-heavy is better for young people and safe investments are better for older people.

Once you invest money in a 401(k), your dollars stay invested until you are at least 59 ½ years old. Withdrawing funds before this magic age usually means paying at least a 10% penalty, in addition to taxes. You can, however, withdraw early in certain circumstances.** Don’t count on these exceptions, though. Once you invest money in a 401(k), it’s a good idea to just plan on leaving it there until you retire.

Traditional vs Roth 401(k) plans

With a traditional 401(k), you pay into your account tax-free, and only pay taxes when you withdraw the money. This is an ideal situation if you think you’re in a higher tax bracket now than you will be when you retire. It seems like a no-brainer that your income while you’re working will be higher than when you’re not, but remember that capital gains and, of course, your retirement funds will count as income when you withdraw.

With a Roth 401(k), like a Roth IRA, you pay taxes now and withdraw tax-free when you reach 59 ½. The benefit of this is that a dollar invested into your 401(k) now grows to many dollars over 40 years, so you’ll have more money to pay taxes on later in life. Plus, as a student, you’re probably making less money now than you will as your career advances, so you can take care of taxes while you’re verging on broke. On the other hand, it’s hard to predict the tax landscape in 2051.

You can – and many do – hedge your bets by splitting your contributions between those two plans. Keep in mind, though, that contribution limits apply to the combined 401(k) plans, so you can’t double your contribution by investing in a Roth and a traditional plan.

401(k) vs IRA plans

Aside from who controls the investment plan, there are a few other differences between an IRA and a 401(k):

  • Contribution limits to a 401(k) are much higher than to an IRA: they’re capped at $16,500 if you’re under 50 and $22,000 if you’re older, while IRA contributions are limited to $5,000 and $6,000.
  •  Since an IRA isn’t employer-dependent, your employer won’t match your contribution.
  • Your employer will probably pay any administrative fees, but you’re on your own with an IRA.
  • Many plans allow you to take out a loan from your 401(k), to be repaid with after-tax funds at a predetermined interest rate. This loan isn’t taxable, nor is it subject to a 10% early withdrawal penalty, and the interest is added to your 401(k).

Changing jobs

Since a 401(k) is employer-based, where your contributions go changes when you switch jobs. When you leave your job, you can:

  • Take the money and run. This is a pretty bad idea. First, you pay a 10% penalty; second, the government takes 20% as a federal tax withholding; third, you’ll have to pay taxes above that withholding; fourth, and possibly most importantly, you’re losing out on all the interest that that money could have made you.
  • Leave your money in your old 401(k). If you like your current plan, or you think you don’t have enough options in your new job, you can keep your old account. Plus, you can always roll it over later. Your account balance must be greater than $5,000 to leave it at your old job.
  • Rollover to the new 401(k). You can move your old 401(k) money into your new account, tax- and penalty-free.
  • Rollover to your IRA. This option gives you the most flexibility – you can choose the plan that’s best for you, not just one of your employer’s limited options. You can always move the funds to a 401(k) or Roth IRA. However, your on your own for administrative fees and you can’t borrow against your IRA. Plus, if your 401(k) includes company stock, you may get preferential tax treatment unless you move the stock to an IRA.

How much should you invest in your 401(k)?

As the first cohort to extensively use 401(k) plans retires, it’s clear they struggled to save enough. According to a Boston College study, the median household of a 60-62-year-old with a 401(k) had less than 25% of what they needed to maintain their standard of living during retirement. Even counting other benefits like Social Security or pensions, many soon-to-be-retirees fell short. The previous generation didn’t save enough, and now they’re suffering for it. You should save early and often so you don’t make the same mistake.

Many employers will match contributions to your 401(k) plan up to a certain amount. If this is the case for you, do everything you can to contribute at least that much to your plan. Employer matching incentives are a great way to maximize the benefit of the plan. You can think of it as free money.

Read the fine print of your plan! Many 401(k) plans have provisions which may come back to bite you if you switch jobs. If you have less than $1,000 in your plan, you may be required to cash out when you switch jobs. In this case, you’ll get slapped with a 10% penalty, be subject to unpaid income taxes if it’s a traditional 401(k), and have to start over saving for retirement.

Less drastically, if you have between $1,000 and $5,000 in your account, your employer will automatically transfer your assets into an IRA.

In general, contribute as much as you’re able. Even if you’re cash-strapped, try to make a habit of contributing whatever small amount fits your budget. It’s critically important to let time work in your favor with a 401(k) plan. Even a small investment each month can become a million dollar nest egg by the time you retire.

**Cases in which you can withdraw from your 401(k) without penalty:

  • You die and the funds go to your beneficiary
  • You become disabled
  • You’re unemployed and over 55
  • You need the money for qualified medical expenses over 7.5% of your gross income
  • A qualified domestic relations order (ie, divorce)
  • The money is a dividend from employee stock ownership
  • http://www.nerdwallet.com/ NerdWallet

    Hi @Mila! It’s great that you are looking to switch to a card with a lower annual fee and lower interest rate. There are some credit cards on the market that offer a higher cash back rewards rate than 1%. As of December 2014, the Citi Double Cash is offering 1% cash back when you make a purchase, and another 1% cash back when you pay for it. The Capital One Quicksilver is offering a 1.5% cash back on all purchases. I’ve included some links below if you’d like to learn more.

    Citi Double Cash: http://www.nerdwallet.com/blog/credit-cards/citi-double-cash-credit-card-review/

    Capital One Quicksilver Cash Rewards: http://www.nerdwallet.com/card-details/card-name/capital-one-cash-credit-card

  • Jessica Rogers

    I have a question on this cards with travel perks. Can I buy my fiances flight with my points? Or do I have to be the traveler?

    • http://www.nerdwallet.com/ NerdWallet

      Hi Jessica,

      Congrats on being engaged!

      Yes, you can buy a ticket for your fiance depending on the program. For example, as of January 1, 2015, Chase will allow you to use your Ultimate Rewards points earned with the Chase Sapphire Preferred to purchase a ticket for someone else. However, all the confirmation communications will be sent to you.

      Hope this helps!

  • http://www.nerdwallet.com/ NerdWallet

    Hi @Matt Berman – The Amex Blue Cash Everyday is a great card. If you are looking to supplement, I would consider the BankAmericard Travel Rewards card: http://www.nerdwallet.com/card-details/card-name/BankAmericard-Travel-Rewards/?utm_source=zendesk&utm_medium=comments It has no annual fee (which is good, since you don’t spend too much per month), but as of 1/12/2015 you still earn 1.5% rewards per $1 on every purchase, which can be redeemed as a statement credit to cover travel expenses. I would still continue to use the Amex Blue Cash Everyday on groceries and gas stations, and use the BankAmericard for everything else.

  • http://www.nerdwallet.com/ NerdWallet

    Hi @Jen – The Capital One Venture card has a higher rewards rate (2%) than the BankAmericard Travel Rewards (1.5%), but it does actually have a fee of $59, although that’s waived for the first year. So, for the first year, the Capital One is better. For year 2 onwards, it’s better to get the BankAmericard if you’re planning to spend less than $12,000 per year. If you spend more than $12,000 per year, the extra rewards with the Capital One make up for the annual fee. Hope this helps!

    • Jen

      Thanks NerdWallet! I see that you have the Chase Sapphire Travel Rewards card as the best travel card. How much would I have to spend a year to make it worth the $95 annual fee?

  • Jordan Dobbs

    Hello everybody that’s reading this im brand new to this whole credit card thing ive actually never had a credit card and am really considering signing up for one in the next few days. I was looking at the above article and one of the cards says I will receive a $100 bonus after spending $500 on purchases in my first 3 months from my account opening and im not really sure exactly what that means can someone please explain to me what this means?? Also what does it mean when it says up to $1500 spent per quarter? Does it mean that I have to spend at least that much every quarter of the year and there is 4 quarters in every year? Actually one last thing lol it says an annual fee of $89 what is meant by an annual fee?? Thank you for ur time and patience with answering all of my questions have an amazing day!!

    • Jen

      Your credit card bill is monthly like any other bill. If you charge at least $500 in the first 3 billing cycles you will receive a $100 rewards bonus on top of your regular rewards earning (say you earn 1.5 point per dollar spent you’d get 750 points for charging $500). I think you’re referring to the Discover card with up to $1500 per quarter. Discover has a rewards program where you earn 5% cash back on specific types of spending per quarter. You earn 5% back up to $1500 spent in the category per quarter (so if groceries is the category for the 5% cash back and you spend $1600 in groceries in that quarter (3 month period) you’ll earn $75 (5% cash back on $1500) and $1 cash back (1% cash back on the other $100 spent on groceries) if you spend $1,000 in groceries during the quarter you’ll get $50 cash back. Some cards charge a yearly fee so you will be charged $89 a year if you have that card (I always look for cards without an annual fee).

  • John

    I am looking for the best card for rewards towards hotels. I primarily charge gas groceries and some utility bills ….any help?

  • Jordan Dobbs

    whole credit card thing ive actually never had a credit card and am really considering signing up for one in the next few days. I was looking at the above article and one of the cards says I will receive a $100 bonus after spending $500 on purchases in my first 3 months from my account opening and im not really sure exactly what that means can someone please explain to me what this means?? Also what does it mean when it says up to $1500 spent per quarter? Does it mean that I have to spend at least that much every quarter of the year and there is 4 quarters in every year? Actually one last thing lol it says an annual fee of $89 what is meant by an annual fee?? Thank you for ur time and patience with answering all of my questions have an amazing day!!

    • http://www.nerdwallet.com/ NerdWallet

      Hi @Jordan Dobbs – It’s great that you are researching credit cards and interested in building your credit history! Here are some basics that will help:

      Sign-up bonus: This is a bonus that you receive (either cash or points) after meeting a minimum spending threshold in a certain time period. In your example, you receive $100 cash back if you spend at least $500 on purchases (actual goods and services… a balance transfer, cash advance, or fees don’t typically count towards this).

      Rewards cap: The $1500 spent per quarter is a limit on the benefits you can receive. If you are receiving extra bonus rewards on a certain category (groceries, for example), the card will only give you the extra rewards for up to $1500 that you spend in the three-month period. You don’t need to spend that much to get the benefits!

      Annual fee: This is the fee that you are charged each year by the credit card companies.

      I hope this helps! If you have more questions about credit cards, you can check out our handy guide here: http://www.nerdwallet.com/codex/credit-cards/what-is-credit-card/?utm_source=zendesk&medium=comments

  • Jim Weid

    Hi Nerdwallet,
    I spend about 10,000 a month from a company in canada. I live in US. I am looking for a card that receives rewards without international fees. Thank you.

  • TrippleJay16

    Looking for a CC to fill a rewards gap in my wallet. I am a consultant who travels Monday to Thursday. My Company and its clients use the following hotels: Hilton, Hyatt, Marriott, IHG (i believe). The company uses the following airlines: United, Delta (main) and AA. The hotel we stay at depends on the project, with each project lasting up to 6 months at a time.

    So I am looking for a card to take advantage of hotels, restaurants and rental cars.

    Will be staying at Marriott for ~45-60 nights (Jan-June).

    My current cards are :

    1. AMEX Gold Premier ( used to book directly with airlines)
    2. AMEX Blue Cash Preferred (groceries, gas and department stores)
    3. AMEX Everyday (sock drawer)
    4. Discover IT (5% cash back categories)
    5. BOA Travel Rewards (Sock drawer)

  • Socks

    I know Turkish airlines is aligned with United, not sure about the others. It seems that a United rewards card may be more suited for you there. AA is certainly better for people that fly to South America.

  • Traci Sandler

    Hi NerdWallet,
    I’m looking to supplement with a card that will accrue rewards for domestic flights. What’s the best card for that and how much should I spend
    monthly/annually to make it worth it?
    I currently have the AMEX Starwood Preferred Guest card and spend $3,000-$4,000 per month. I’m happy with this card because we utilize the points often, but not everywhere takes AMEX so I’m still using my bank card for some purchases.
    I’m also open to shifting some of the AMEX spend to the new card to ensure I get the most out of both cards.

  • LisaH

    HI Nerd Wallet –

    Planning on taking a big trip to Disney next year – and we’d like to get as much credit card bonuses/savings as possible in the next year to help pay for it…do you recommend the Disney Chase card, or one of these reward cards?

    Thanks!

  • http://www.nerdwallet.com/ NerdWallet

    Hi Meanrn. Cash back is a great option because it gives you the ultimate flexibility in how you use your rewards. If you like simple, flat-rate rewards, the Citi Double Cash is a great card – As of December 2014, you earn 1% cash back when you buy, and another 1% cash back as you pay for those purchases. You don’t have to worry about enrolling in any rotating categories. On the other hand, if you like to earn high rewards you can try the Chase Freedom. It’s offering a $200 cash back bonus after spending $500 within the first 3 months from account opening (until December 17th, 2014!). You earn 5% cash back on up to $1,500 in combined purchases per quarter for rotating categories, and an unlimited 1% cash back on all other purchases. I’ve included some links below for more information.

    Citi Double Cash: http://www.nerdwallet.com/blog/credit-cards/citi-double-cash-credit-card-review/

    Chase Freedom: http://www.nerdwallet.com/blog/credit-cards/chase-freedom/