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A 401(k) is a type of workplace retirement savings plan. As an employee, you can choose to defer some of your salary and put that money into your 401(k) plan.
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These plans are sponsored by your employer. So, unlike an individual retirement account (IRA), you can’t set up a 401(k) plan on your own. There are several different types of 401(k) plans available to employers; if you choose to participate, you will be enrolled in the plan that your employer has selected.
Two common kinds of 401(k)s are traditional and Roth 401(k) plans. In many ways, these two plan types are similar. Unlike an IRA, they do not have an income limit to participate. Both are subject to the same annual contribution limit, which is much higher than the contribution limits placed on IRAs.
To boost contributions even further, you might consider catch-up contributions. If you’re 50 or older, you can make these so-called catch-up contributions for eligible 401(k) plans. These allow you to contribute more than the annual contribution limit to your plan. While they can help turbo-charge your savings as you near the retirement finish line, you don’t actually have to “be behind” in your savings to take advantage of catch-up contributions.
When it comes time to withdraw your money in retirement, traditional 401(k) plans have certain distribution requirements, which typically must begin the year you turn 70 1/2. Because Roth 401(k) contributions are made with after-tax dollars, the withdrawals are not subject to the same required minimum distributions.
IRS.gov. Data as of 2016.
Similarities aside, traditional and Roth 401(k) plans differ in how they are taxed. A traditional 401(k) plan is sometimes referred to as a pre-tax 401(k), meaning that you contribute to the plan with before-tax dollars. But, because you didn’t pay taxes on the money you put into the plan, you will have to pay taxes (both federal and most state income taxes) when you withdraw the money.
With a Roth 401(k) plans, the opposite is true. You contribute a portion of your salary to your Roth 401(k) plan with after-tax dollars. Because you’ve already paid taxes, when you begin to make withdraws from the plan, that income will not be taxed – if it is what’s called a qualified distribution. A distribution (or withdrawal) is considered qualified if you have had the account for at least 5 years and you made the withdrawal due to disability or on or after you turn 59 ½ (the age at which you can start to withdraw money from the account without incurring an early-withdrawal penalty).
IRS.gov. Data as of 2016.
Aside from obvious tax implications and early-withdrawal penalties, there are other considerations when choosing a withdrawal strategy for your 401(k) plan. While many people take all their money out of their savings plan when they retire and roll it into an IRA so they can manage it on their own or with an advisor, it may be beneficial to remain at least partially invested in the plan.
Many plans actually want you to stay in the plan, as they can negotiate lower fees with vendors when they have more assets. These lower fees may make it advantageous to stay in the plan versus buying outside à la carte.
In addition, if your 401(k) plan is invested in a target date fund, it may offer an investment mix that's designed to help meet the needs of people in retirement.
401(k) plans can be a very useful tool in saving for retirement, particularly if you take advantage of features that your plan may offer to help maximize your savings. There are many different ways to start saving for retirement. The trick is to find the right combination of savings plans and tools that work for you. For more on what to consider when selecting a plan, the IRS website offers valuable insight.