There are many reasons to use a 401(k) as a savings tool. It allows you to divert some of your earnings to a special account and avoid having it taxed along with the rest of your income. And many employers offer a matching program. They’ll also deposit money into your account to match the money you put in, up to a certain amount. These features alone will help your savings grow at a faster rate than if you were to use a standard savings account. There are several different types of 401(k) plans, each with unique pros and cons. They include the traditional 401(k), a self-directed plan, a safe-harbor plan, a SIMPLE 401(k), a Roth 401(k), and a tiered profit-sharing plan structure.
How Does the Standard 401(k) Plan Work?
These plans are designed to help you build wealth over time. You’ll set a dollar limit or a percentage of your pay that you want to contribute to your account each pay period. This is why you might also hear 401(k)s referred to as “defined contribution” plans. The money comes directly out of your paycheck before taxes are calculated on the balance. You might be saving more than you put in if your employer offers a match program. Your employer will choose a plan provider that will build wealth for you by investing the funds you’ve contributed in any number of assets. These can include mutual funds, stocks, index funds, and real estate investment trusts (REITs). You may be able to choose how your funds are invested in some cases, or at least how safe you’d like the account managers to be with your money. The perks are clear, but there are downsides as well. These plans are designed to work over the long term, so it’s generally not advisable to take money out. You can incur fees for early withdrawal if you do. And those taxes that you didn’t have to pay when you put the money into your account will come due later when you take withdrawals.
The Roth 401(k)
A Roth 401(k) is a special type of plan that has many of the same benefits of a Roth IRA. The money you add to the plan comes from after-tax dollars. Contributions to Roth 410(k) plans count in your gross income each year, so you don’t get a tax break when you add money. But you won’t pay a penny in income tax or capital gains tax on that money, even if it grows to tens of millions of dollars by the time you retire.
The Small Business 401(k)
A self-employed 401(k), also known as a “solo 401(k),” can be a great choice for small business owners or those who work for themselves. It has many features that may make it more attractive to small business owners than the simplified employee pension individual retirement account (SEP-IRA). Owners make contributions with pre-tax dollars, which are allowed to grow tax free until they’re withdrawn during retirement. As with all 401(k) plans, the IRS has limits on the amount a self-employed person can contribute to the plan. Many people qualify for a solo 401(k) without even being aware of it. With its larger contribution limits and wider range of qualifying investments, this type of plan might help you reach your retirement goals sooner if you work for yourself and have no employees.
Reducing Risk
Most 401(k) accounts give you a degree of control over how much you invest, how you choose to use these funds, and when you can or must withdraw. But there are risks that come with certain actions, so it’s important to know how they will affect your long-term savings goal.
Should You Max Out Your Contributions?
It can be risky to put too much money into your 401(k) account at any one time. First, make sure that your budget can handle it. It can be easy to be swayed by the changes you see in your earnings if this type of account is new to you, whether that’s your reduced paycheck or the growth in your 401(k). Most investments gain over time, so it’s wise to start slowly and steadily.
Should You Take Money Out of Your Account?
It can be tempting to withdraw funds from your 401(k) account if times are tough and you’re struggling to make ends meet. But not every account allows this, and those that do have strict rules. Your contributions will likely pause. You may incur fees, and you may be subject to a harsh repayment plan. Even though it’s your money, taking it out early is actually more like a loan than a withdrawal. Of course, there are times when using the funds in your 401(k) account might be the best or only option you have. Just be sure you understand the risks.
Should You Adjust Your Contribution?
Many people wonder whether they should stop adding money to their 401(k) accounts when the market is down, or if their job is in danger. But a 401(k) account is, in fact, one of the safest places your money can be. Pausing contributions to your 401(k) can be a costly mistake.
What Happens to Your 401(k) When You Leave Your Job?
You have a choice to make about your 401(k) if you leave your job. You’ll be subject to taxes if you close the account and withdraw the funds. The best option is often to “roll it over.” The Rollover IRA is a special account that allows you to move the money in your 401(k) into it and it will protect it from taxes. The Balance does not provide tax, investment, or financial services or advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal.
