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).
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