401(k) plans were established by Congress to encourage individual savings towards retirement. Offered through employers, the plans are generally available to eligible employees who are allowed to contribute a percent of their salary to the plan. In most plans, employees are given a menu of investment options that enable them to create a portfolio that is most suited for their investment preferences and risk tolerance.
Contributions are based on a percent of your salary up to a current maximum of $17,500 ($23,000 under the catch-up provision for people over age 50). If your income exceeds $115,000, there may be some additional limitations depending on how many lower paid employees participate in the plan.
Why You Should Love Your 401(k)
We live in a cynical world where most people have come to realize that there are no free lunches. But when your employer offers you free money, don’t walk away to quickly, because, if it is through your company’s 401(k) plan, the offer is for real.1
In addition, the IRS is allowing you to keep more of your own money that would otherwise have been paid in taxes. And they won’t make you pay taxes on money that you earn inside of your 401(k) plan which can save you a significant amount of money over the period of time you are saving for retirement.2 How does all of this happen?
When you make a contribution to your 401(k) plan, three things happen:
- You receive an immediate reduction in taxes because your contribution, which comes from your salary, is made before you pay any taxes on it.
- If you’re employer provides a matching contribution, you receive free money instantly. A typical match is 50% up to 6% of your contribution1
- Once your contributions are invested, they begin to grow tax deferred which means you don’t owe any current taxes on their earnings.
Another Way to Save Money
Although it’s not recommended, you can borrow from your 401(k) if your employer’s plan allows it. Loans can be made at a very reasonable interest rate of 4% to 5% which, when compared to credit card interest at 18%, could make it a viable debt reduction option. You need to make payments and have it fully repaid within five years, or it will become taxable and an early withdrawal penalty of 10% may apply. The good news, it that you will paying interest to yourself! Another caveat: If you leave your employer and the plan, you will need to repay the loan within 60 days or taxes and penalties will be assessed.
Loans from your 401(k) should be a last resort. If you are swimming in debt, and you need relief from high interest debt, it can be a way out, but consider other alternatives first.
Every 401(k) plan has its own rules and limitations established by the employer, so it is important to carefully review the plan document. For instance, employers who match their employees contributions often include a vesting schedule which means that you need to stay with the company for a certain period of time before you are able withdraw the contributions from your employer.
Some plans don’t allow for loans, and those that due can attach their own requirements and charges which could increase the cost of the loan.
1Employers are not required to provide matching contributions. For employers who do match employee contributions, the amount or percentage of the employer contribution can vary from employer to employer.
2 Earnings inside a 401(k) plan are allowed to accumulate free of taxes, but withdrawals made from the plan are taxed at ordinary income tax rates. Early withdrawals made prior to age 59 ½ may incur a 10% penalty unless certain conditions are met.