A 401(k) is an employer-sponsored, tax-deferred retirement plan. It allows employees to take a portion of their paychecks and contribute it to a savings plan. The employees get to choose several investment options (bonds, mutual funds, index funds, etc.) to encourage their contributions to grow. As time goes on, the savings plan should create a comfortable nest egg.
Your workplace may have offered this plan as part of their benefits package. If you’ve signed up for one, you should learn the following things about it.
1. Types of 401(k)s
There are two types of 401(k) plans that you are likely to encounter: a traditional 401(k) and a Roth 401(k).
A Traditional 401(k)
A traditional 401(k) allows employees to deduct their contributions from their annual taxable income. One important thing to know about the traditional plan is that you will pay income taxes for your 401(k) withdrawals once you’ve retired.
A Roth 401(k)
A Roth 401(k) doesn’t accept tax-deferred contributions. Employees must make contributions with after-tax dollars. On the plus side, an employee’s withdrawals in retirement will not be taxed.
These are some other types of 401(k) plans:
- Solo 401(k): a retirement plan for self-employed individuals.
- Simple 401(k): a simplified version of a traditional 401(k)plan designed for businesses with less than 100 employees.
- Safe Harbor 401(k): a version of a traditional 401(k) that makes it mandatory for employers to provide contributions. In return, employers can skip an annual non-discrimination test.
- 403(b): a retirement plan for certain employees at public schools, churches and tax-exempt organizations.
2. Matching Contributions
If you have a traditional 401(k), your employer might offer matching contributions. Essentially, your employer will agree to match certain contributions that you add to the fund, automatically giving your retirement savings a boost. They may agree to match up to a specific dollar amount or percentage. You can try your best to max out these contributions to get the most out of this benefit.
If you have a Roth 401(k), you will not be able to access matching contributions.
3. Early Withdrawals
A 401(k) is specifically designed for your retirement years. Removing funds from your 401(k) before you reach the age of 59 ½ is called an early distribution/withdrawal. You will technically be able to make an early withdrawal, but it will come with certain penalties:
- The IRS may automatically withhold 20% of your withdrawal for tax purposes.
- The IRS may charge you an additional 10% penalty.
- You will lose out on the savings meant for your retirement years.
You should refrain from making early withdrawals unless it’s absolutely necessary. If you’re trying to pay off an urgent expense, use your employer-sponsored emergency savings account or personal emergency fund to cover it. If you don’t have an emergency savings account or emergency fund, you should consider an alternative payment method before turning to your 401(k) for assistance.
One alternative payment method would be an online loan available in your state of residence. So, if you live in Dallas or Austin, you could search for a source for online loans in Texas during your emergency. Doing this will help you access loan options available in Texas.
As long as you meet the qualifications for an online loan in Texas — or whatever your state of residence happens to be — you can apply. You just might get approved. Then you can use the borrowed funds to recover from your emergency and manage repayments later on.
Use this knowledge of 401(k)s to your benefit and get the most out of your savings account.