When you talk about retirement, saving, and investing, the term “401k” likely comes up. But do you have a full grasp of what a 401k really is? One of the most common investment vehicles, a 401k is a tax-advantaged, employer-sponsored plan that allows you to save for retirement in a tax-sheltered way to help maximize your retirement dollars. Sometimes, your employer may even contribute to your plan.

Having a 401k to contribute to is extremely valuable as you plan your long-term retirement goals. There are certain topics and strategies that you should keep in mind in order to best optimize your 401k to meet your personal financial goals.

In addition to our free financial tools, which can help you take control of your money with tools like the Retirement Planner and Investment Checkup, we are now introducing this 401k Hub, a centralized resource for all of your 401k needs. Here we’ll tackle key aspects to keep in mind if you are just beginning to build your nest egg, or if you are further down the road in your financial journey.

401k Contributions

Contributing to a 401k as soon as possible can be a small act with large repercussions. Prior to the COVID-19 market crash in March 2020, Personal Capital took a look at 401k average balances by age, which show the long-term effects of compound interest, and disciplined, strategic investing in a 401k.

Now that you know the potential positive effects of contributing to a 401k as soon as possible, let’s dive in to key details you should keep in mind as you put money aside into your plan.

401k Withdrawals

Now that you are familiar with contributing to a 401k, let’s talk about rewarding yourself with the fruits of your labor by withdrawing money from your accounts to fund the retirement life you worked so hard to enjoy.

To begin, 401k plan rules may not allow you to take regular withdrawals unless one of several events has occurred. Some examples include turning age 59 ½ or leaving your job. If you do qualify to take withdrawals, be aware that there are certain requirements that must be met if you want to avoid paying penalties.

Taking a distribution from your 401k prior to turning 59 ½ may cause you to owe federal income tax (taxed at your marginal tax rate), state income and other related tax, and a 10% penalty on the amount you withdraw. You may be able to withdraw penalty-free from your current employer’s 401k (but not an older 401k) if you separate from employment after age 55 from the employer where the plan is currently in place. Given these consequences, withdrawing from a 401k early is usually not ideal.

Once you reach the age of 59½, the IRS allows you to take penalty-free withdrawals from your retirement accounts. Due to the newly-passed SECURE Act, Required Minimum Distributions (RMDs) are required after someone turns 72 years of age.

Can I Withdraw Early?

If you are in dire need of money and are thinking about withdrawing from your 401k even though you do not meet one of the requirements, depending on your situation and the plan’s rules, you may qualify to take withdrawals.

One option is a loan from your retirement plan, which the IRS limits to either half the vested account balance or $50,000, whichever is less. The loan will need to be paid back, and does charge interest, though the interest goes into your account so you are essentially paying yourself the interest. Various plans have different rules around plan loans, so reach out to your plan administrator for all the details.

Another option is known as “Hardship Withdrawals,” which are designed to let participants withdraw money from their employer retirement plans if they’re facing financial difficulty. Some hardship withdrawals may qualify for an exception from the 10% penalty, while others may not, but remember that pre-tax withdrawals almost always cause ordinary income tax. Some plans may also add restrictions following a hardship distribution, so check with the plan for details before taking action. Finally, remember that many distributions from employer plans have mandatory 20% withholding. Pulling money from your employer’s retirement plan is usually not a good idea unless absolutely necessary.

See below for some of the reasons why a Hardship Withdrawal could be allowed:

401k Employer Matching

Employer matching of your 401k contributions means that your employer contributes a certain amount to your retirement savings plan based on the amount of your annual contribution.

If you are not able to max out contributions, then it may be the best strategy to contribute the minimum amount required to take advantage of your employer’s contributions to your 401k.

Here are the common types of matches to keep in mind:

Be sure to check on your company’s 401k vesting policy. While some employers immediately transfer the ownership of matched funds, others may delay the transfer several years in order to support employee retention.

401k Distributions

As you prepare for retirement, there are two key numbers you should always keep in mind: 59 ½ and 72.

When you approach the times in life when you are about to withdraw money for your retirement, be sure to understand the Required Minimum Distributions set by the IRS.

Here is something to keep in mind: RMDs do not have to be spent. They are required to be withdrawn from tax-deferred accounts starting with the year you reach age 72, but if you don’t need to spend the money, it makes a lot of sense to simply transfer it to your taxable brokerage account and invest it there.

If RMDs will likely increase your income tax bracket in retirement, you may want to consider a couple of strategies as you plan ahead for tax savings.

One idea is to withdraw or convert money from your tax-deferred accounts when you are in a low-income year. For example, doing a Roth conversion could make sense if it doesn’t increase the current tax bracket but would decrease a future tax bracket by decreasing the RMD amount. This is the type of calculation you should discuss with your financial advisor.

You also might want to consider using your RMD distribution as a charitable gift, which is commonly known as the Qualified Charitable Distribution. The amount you give can help lower your tax bracket. Make sure to consult with your tax advisor before implementing this type of strategy.

401k Rollovers

Say for example you decide to leave your employer in the future. You may be inclined to just leave your money in the old employer’s 401k plan and not touch it as a way for you to have it “out of sight, out of mind.” Here are reasons to rethink that approach.

Types of 401ks

Investing and saving for retirement is not a straightforward, easy task. There are endless variables such as life stages, personal goals, varying living costs, and different types of investment vehicles that can sometimes overwhelm individuals and turn them away from controlling their financial situations.

In addition to 401k options, which we will explore deeper below, there are a broad range of investment vehicles that could be beneficial for building up your nest egg, such as traditional or Roth IRAs, SEP IRAs, SIMPLE IRAs, Self-Directed IRAs, 457, and 403(b) plans.

When it relates to your 401k plans, there are primarily two options: Traditional 401k and Roth 401k.

Traditional 401k contributions are made with pre-tax dollars, ultimately reducing your taxable income and allowing your contributions to grow tax-deferred until you withdraw your money in retirement. Traditional 401ks can potentially be more beneficial if you think you will be in a lower marginal tax bracket when you start withdrawing funds in retirement.

In contrast, Roth 401k contributions are made with after-tax dollars. This option gives you tax-free growth and — as long as you follow the rules — fully tax-free withdrawals once you reach 59 ½ and the account has been in place for 5 years. Roth 401k users can contribute up to $19,500 per year, and individuals aged 50 and over may contribute up to an additional $6,500, just like with traditional 401k options.

Roth 401k plan participants who plan to withdraw from their Roth 401k prior to turning 59½ may be subject to a 10% withdrawal penalty on a portion of the withdrawn amount. Unlike with a Roth IRA, Required Minimum Distributions (RMD) are mandated with a Roth 401k starting at age 72.

Roth 401ks are typically good for people who think they will be in a higher tax bracket in the future. With a Roth 401k account, individuals aged 59½ or older do not pay taxes on their withdrawals. These accounts continue to grow tax-free. What’s more, you can avoid RMDs by rolling the plan into a Roth IRA upon reaching age 59½ or leaving your employer. For these reasons, Roth IRAs can be an effective legacy planning tool.

Next Steps

Now that you are well-equipped to position your 401k toward meeting your retirement goals, here are final steps to consider in order to stay on track to retirement:

This content was originally published here.

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