- 401(k) Basics: Everything You Need to Know
- Benefits of a 401(k)
- Contribution limits
- Income limits
- 401(k) withdrawal rules
- Required minimum distributions
- Rule of 55
- 401(k) loan
- Explore related retirement topics
- What is the rule of 55?
- How to make the best use of the rule of 55
- What To Do If Your Employer Suspends 401(k) Matching Contributions
- How Employer 401(k) Matching Contributions Work
- Employers Are Suspending 401(k) Matching Contributions — Again
- 1. Think carefully before withdrawing money from your 401(k) account
- 2. Time to review your investment strategy
- 3. Maintain your retirement contributions — or increase them
- Suspensions won’t last forever
401(k) Basics: Everything You Need to Know
Updated: Feb. 16, 2021, 1:46 p.m.
A 401(k) is a tax-advantaged retirement account, usually offered through an employer. Employees may elect to defer a certain percentage of their paychecks to their 401(k)s, and employers often match some of these contributions.
The various types of 401(k)s differ in eligibility requirements and how they are taxed. Here's everything you need to know if you're thinking about contributing to a 401(k).
Benefits of a 401(k)
Placing your savings in a 401(k) confers many advantages. Here are some of the most important ones:
- Tax savings: Contributions to traditional 401(k)s are made with pre-tax dollars, which reduces your taxable income for the current year. The contributions are tax-deferred, which means that you instead owe taxes when you withdraw funds in retirement. If you are in a higher tax bracket today than you expect to be in retirement, then deferring the tax liability can save you money.
- High contribution limits: 401(k) contribution limits are much higher than contribution limits for Individual Retirement Account (IRAs).
- Employer match: Employers often match a percentage of their employees' contributions. This is getting a bonus and reduces how much you need to save for retirement on your own.
- Automatic contributions: You can elect to defer a percentage of each paycheck to your 401(k), so that you don't have to make retirement contributions manually. You can also change your contribution percentage at any time.
- Rollovers: If you leave your employer, you may keep your retirement savings in your old 401(k) or roll over the funds into your new company's 401(k) or an IRA.
401(k)s are company-sponsored retirement plans, so as soon as you meet your company's eligibility requirements, you may enroll and decide how much of each paycheck you would to contribute. Some companies automatically enroll employees in their 401(k) plans. Check with your company's HR department to learn more about your plan.
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These are some of the key 401(k) rules and limits of which you should be aware if you plan to contribute to this type of account.
You may contribute up to $19,500 to a 401(k) in 2020 and 2021, unless you are age 50 or older, in which case you may make an extra catch-up contribution of up to $6,500. These contribution limits can change yearly.
People classified by the IRS as highly compensated employees (HCEs) — those who own more than 5% of the company for which they work or earn more than $130,000 annually in 2020 and 2021 — may not be eligible to contribute to their 401(k)s up to the maximum limits.
Learn the 401(k) rules for highly compensated employees
401(k) withdrawal rules
Here’s a closer look at some of the rules that apply to 401(k) withdrawals.
You may take money your 401(k) at any time, but you will pay a 10% early withdrawal penalty if you do so before age 59 1/2, unless you have a qualifying exception. Qualifying exceptions include large medical expenses, educational expenses, and first-home purchases, among others.
Required minimum distributions
Required minimum distributions (RMDs) are mandatory distributions from 401(k)s that must begin when you turn 72. Before 2020, RMDs were required to begin at age 70 1/2.
Calculate your RMD by dividing your 401(k) balance by the distribution period next to your age in this table.
Failure to annually withdraw at least this much triggers a 50% penalty on the amount that you should have withdrawn.
Adults ages 72 and older who are still working may delay RMDs from their current 401(k) until they retire, though if they have any IRAs or old 401(k)s from former employers, they must still take their RMDs from these accounts starting at age 72.
Rule of 55
The Rule of 55 permits those who quit their jobs or are fired in the year they turn 55 or later to take penalty-free withdrawals from their 401(k)s even if they are younger than 59 1/2.
Public safety workers are eligible for penalty-free distributions if they leave their jobs after they turn 50.
You may take penalty-free distributions only from your most recent 401(k), not from other retirement accounts.
Some 401(k)s enable participants to borrow money from their plans and pay it back over time with interest.
A 401(k) loan can for some people be a nice alternative to a traditional bank loan, but withdrawing funds could slow the growth of your retirement savings.
If you are unable to pay back the full amount that you borrowed by the end of the loan term, the outstanding balance is considered a distribution and taxed accordingly.
While the traditional 401(k)s is most common, there are a few other kinds of 401(k)s:
|This is much the same as a traditional 401(k), except that contributions are made with after-tax dollars. Contributions to Roth 401(k)s don't reduce your taxable income for the current year, but rather are distributed tax-free in retirement.|
|A solo 401(k) is available only to self-employed people. This type of 401(k) effectively has higher annual contribution limits because you can contribute as both employee and employer.|
Explore related retirement topics
Check out other retirement plans that may be right for you
Learn the basics of individual retirement accounts.
For many Americans, the balance of their 401(k) account is one of the biggest financial assets they own — but the money in these accounts isn't always accessible, as there are restrictions on when you can access it.
401(k) plans are meant to help you save for retirement, so if you take 401(k) withdrawals before 59 1/2, you'll generally owe a 10% early withdrawal penalty on top of ordinary income taxes. However, there are limited exceptions.
For instance, if you incur unreimbursed medical expenses that exceed 10% of your adjusted gross income, you can withdraw money from a 401(k) penalty-free to pay them.
Similarly, you can take a penalty-free distribution if you're a military reservist called to active duty.
Because the exceptions are narrow, most people must leave their money invested until 59 1/2 to avoid incurring substantial tax costs. However, there is one big exception that could apply if you're an older American who needs earlier access to 401(k) funds. It's called the “rule of 55,” and here's how it could work for you.
Image source: Getty Images.
What is the rule of 55?
The rule of 55 is an IRS regulation that allows certain older Americans to withdraw money from their 401(k)s without incurring the customary 10% penalty for early withdrawals made before 59 1/2. The rule of 55 applies to you if:
- You leave your job in the calendar year that you will turn 55 or later (or the year you will turn 50 if you are a public safety worker, such as a police officer or air traffic controller). You can leave for any reason, including because you were fired, you were laid off, or you quit.
- You are withdrawing funds only from a 401(k) account offered by your most recent employer. You cannot withdraw money penalty-free from accounts with other past employers, nor can you make penalty-free withdrawals from an IRA, even if you rolled over your 401(k) into one upon leaving your most recent job.
One common misconception is that you can leave your job before the calendar year you turn 55 and the rule will still apply to you. This is not the case. If you are turning 55 in 2021 and leave your job December 31, 2020, the rule does not apply to you.
How to make the best use of the rule of 55
The restrictions of the rule of 55 make it vital to use smart planning techniques. First and foremost, you need to time your early retirement so that you don't leave your job before the year in which you'll turn 55.
Second, if you want to maximize the amount of money you can withdraw without penalties, you should take advantage of rollover options to move as much money as you can into your current employer's 401(k) before leaving your job. For example:
- Many companies allow you to roll over 401(k)s from old employers into your new employer's account.
- Many also enable you to move money from an IRA into your workplace 401(k) if the money got into the IRA when you rolled over an old workplace 401(k).
Any money in your current employer's 401(k) account when you leave your job will qualify for the rule of 55, so using rollovers to put as much money into that account as possible provides you with the most flexibility. If you don't roll the money from old 401(k)s or rollover IRAs into your current 401(k) before leaving, you won't have the option to withdraw without penalty until age 59 1/2.
Finally, remember not to roll over your eligible 401(k) account into an IRA after quitting at 55 or older. Doing so will cause you to lose the exemption and subject you to penalties for withdrawals until you hit 59 1/2.
Having access to money is vital for retirees, especially if you end up having to retire early or unexpectedly. Knowing the rules about getting access to your 401(k) at 55 or older can be a lifesaver for your finances.
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What To Do If Your Employer Suspends 401(k) Matching Contributions
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Thanks to the COVID-19 crisis, your investment portfolio has most ly taken a hit. But there may be even more retirement related fallout from the coronavirus pandemic: Your employer could freeze their 401(k) matching contributions.
As companies struggle to cut costs and survive, many are laying off workers and slashing extra expenses. Ari Sonneberg, a partner with the Wagner Law Group, notes that 401(k) matching contributions to employee accounts make an attractive target for cost cutting.
“We certainly saw a decrease in employer contributions during the Great Recession and a significant increase thereafter, and we have, in the last few weeks, been getting many calls from plan sponsors looking for advice on how to properly suspend or reduce employer contributions,” Sonneberg said. “During recessions, employers look to reduce expenses — reducing their retirement plan obligations is no exception.”
If your company is planning on suspending its 401(k) contributions, take these steps to protect your retirement fund.
How Employer 401(k) Matching Contributions Work
For employees, 401(k) matching contributions provide a powerful boost to retirement savings; for companies, they are a useful tool for recruiting and retaining employees.
In recent years, a 401(k) match has become an increasingly common part of benefit packages.
According to Vanguard, 95% of the employers who use it to administer their 401(k)s matched retirement plan contributions by their workers.
With employer-sponsored defined contribution retirement plans 401(k) accounts, employees contribute from their salary, usually on a pre-income tax basis. (According to Vanguard, more than 70% of plans also offer the option of making after-tax Roth contributions.)
Employer matches vary widely in their generosity, but the most common one among Vanguard plans is a 50% match on the first 6% a worker saves. In other words, if an employee saves 6%, the company kicks in 3%.
Some companies offer tiered matches — a common tiered formula matches the first 3% the employee saves dollar for dollar, and then the next 2% at a 50% rate.
In such a plan, if you save 5% of your salary, your employer will kick in 4%.
Let’s say your employer is more generous than average and offers a dollar-for-dollar match on your retirement contributions up to 5% of your salary. If you earn $40,000 per year, your employer will match up to $2,000 of your annual contributions.
Whatever the formula, employer 401(k) matching contributions are essentially “free money,” making them a highly valuable benefit for employees. Taking advantage of an employer’s match could help you dramatically increase your retirement savings.
Employers Are Suspending 401(k) Matching Contributions — Again
Suspending employer contributions to retirement accounts isn’t a new tactic. According to a survey by Willis Towers Watson, almost 20% of companies with at least 1,000 employees suspended or decreased their retirement plan contributions during the 2008 recession.
Already, several large employers, including Haverty’s and Amtrak, have announced that they are freezing their 401(k) contributions in response to financial stress stemming from the coronavirus outbreak, including While 401(k) matching contributions are a key part of a compensation package, your employer can often stop making contributions at will—it’s perfectly legal.
“Many typical 401(k) plans contain provisions for an employer discretionary contribution to the extent that if an employer has been making these types of discretionary contributions, no notice to participants is required by the plan sponsor to stop making them or to reduce them,” said Sonneberg.
However, some employers will need to take certain steps before they can suspend contributions, such as giving employees notice.
If the employer offers a Safe Harbor 401(k), the company is subject to certain notice requirements.
If the employer intends to make midyear changes to the 401(k), such as stopping employer contributions, it must inform employees of the intended change and its effective date at least 30 days in advance.
Non-Safe Harbor 401(k)s generally do not require companies to provide advance notice when freezing matching contributions.
The suspension of 401(k) contributions can be a significant blow to employees. However, Amber Clayton, the knowledge center director with the Society of Human Resources Management, said it’s something companies are only doing as a matter of survival and not as a long-term solution.
“[…] But employers who do this would ly do so in the short-term as 401(k) plans are important for employees as well as potential job candidates,” Clayton said. “A longer suspension could result in turnover or recruitment challenges.”
Finding out that your employer has suspended their 401(k) match can be disheartening. But before making any drastic changes to your own 401(k) contributions, follow these tips to minimize the impact of your employer’s decision.
1. Think carefully before withdrawing money from your 401(k) account
With the economy and stock markets in turmoil, you may have considered withdrawing funds from your 401(k) to have cash on hand to cope with financial hardship.
The Coronavirus Aid, Relief, and Economic Security (CARES) Act made it easier than ever to tap into your retirement fund. Previously, withdrawing money from your retirement accounts before you reached retirement age resulted in a 10% early withdrawal penalty, except in certain circumstances.
The CARES Act waives the penalty for certain people experiencing financial adversity due to COVID-19. (It also gives you up to three years to repay the money to a retirement account and avoid the income taxes that would ordinarily be due on any distribution of pre-tax retirement funds.
However, dipping into your retirement fund can be a costly mistake. Brandon Renfro, a Certified Financial Planner and assistant professor of finance at East Texas Baptist University, recommended that you leave your money where it is.
“Don't give up and withdraw the money that is already in your 401(k),” he said. “That money is still working for you.”
If you take distributions from your 401(k), you’ll lose out on potential growth and market gains when the market recovers. That decision could hurt you later on as you get older.
Need cash now? Consider these options instead.
2. Time to review your investment strategy
While you shouldn’t take out money from your 401(k) if you can avoid it, this would be a good time to revisit your investment allocations.
“The market volatility will have ly thrown your portfolio balance,” Renfro said. “Readjust to get your investment mix back aligned to fit your plan.”
If you don’t have a set investment strategy—or don’t feel comfortable with the current plan you have—it may be worth working with an investment professional or a robo-advisor to choose a new investment mix your goals and risk tolerance.
“It's also a good time to think about how you reacted to the market drop,” Renfro said. “If you panicked or didn't stay the course, then maybe it's time to re-evaluate how you invest. It may be that you need a new plan going forward.”
3. Maintain your retirement contributions — or increase them
Even though your employer may have suspended matching contributions, you can keep contributing to your 401(k) on your own. If you can afford to, contribute more in order to make up for the temporary loss of your employer’s 401(k) match. For 2020, workers can make up to $19,500 in pre-tax or Roth contributions, plus an extra $6,500 if they will be 50 or older by the end of the year.
Alternatively, you might consider redirecting a portion of your retirement contributions to a Roth Individual Retirement Account (IRA). Contributions to a Roth IRA are made with funds on which you’ve already paid income tax, the Roth 401(k) contributions mentioned above, and in many cases offer more flexibility when it comes to investment choices and withdrawals.
“If you are able to, the biggest thing you can do is make up for the reduced employer contribution by saving more yourself,” said Renfro. “Of course, that may not be so easy. It may take some budget trimming, but if you can manage it, you'll be much better off in the long run.”
By staying the course, either in your 401(k) or a Roth IRA, you can continue to grow your nest egg and take advantage of a stock market recovery, when it inevitably arrives. If you can afford to increase your contributions, it will also keep your retirement plans on track.
Suspensions won’t last forever
The COVID-19 financial crisis is impacting companies and employees in many different ways; suspending employer retirement plan contributions is just the latest step as companies attempt to stave off employee furloughs and layoffs.
Because of the sudden and unexpected arrival of COVID-19, many employers have been forced to take drastic steps to stay afloat. While finding out that your employer is suspending its contributions can be frustrating, you should know that it’s ly a short-term phase that will last only until the economy recovers.
“Retirement plan employer contributions are a tool used for retaining existing employee talent and attracting new talent, so as soon as employers are in a position to revisit their contribution suspensions or reductions, history tells us that they will,” said Sonneberg.
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