401(K)s can seem unnecessarily complex when you’re first looking into them. But the gist is that a 401(K) is a saving account you can’t touch until you retire. And – the biggest perk – is that any money you put in comes out before taxes come out.
But, like all money, it’s going to get taxed at some point.
For 401(K)s, that point is when you go to withdraw money. Hopefully, this is when you retire, but I’ll cover some other instances as well. Additionally, any money you have to pay back to your 401(K) gets taxed when it goes in as well as when it comes out.
So be aware of that.
Why Would I Want A 401(K)?
Aside from saving for your retirement? 401(ks) offer a wide range of financial benefits for today you, not just tomorrow you.
Increase Your Takehome
Say you make $60,000 a year and contribute $10,000 to your 401k. Instead of getting taxed for $60,000, you’re only going to get taxed for $50,000. Because the $10,000 in your 401K is shielded from taxation. For now.
In some instances, this could bring you down into a new tax bracket where your taxes are lower, leaving you more savings and more cash in your pocket than you’d have otherwise. This works best if you’re income is on the low end of one tax bracket.
For example, if you make $45,000 per year and you’re filing single, your tax bracket is 22%. So you’d pay $9,900 in taxes and your take-home would be $35,100. At $40,125, however, your taxes jump down to 12%.
So if you contribute $4,875 to your 401(k), your tax bracket would drop. You’d pay $4,815 in taxes and take home $35,310. Certainly not a huge jump – but – you pay less in taxes, save for your retirement, and net an additional $210 in your pocket.
And then there’s the compound interest on the money you rescued from taxes.
While you put money in your 401(K), that money grows.
Say you put $10,000 in there and it gains interest, that interest will gain interest, and that interest’s interest will gain interest. Snowball effect, basically.
Which is great news if you’re too broke to regularly contribute to your 401(k) right now, but still want to prepare for your future.
If you’re interested in seeing the potential growth of your 401(K), here’s a good 401(K) calculator.
Reduced Tax Brackets & Free Money
On that note, when you go to make withdrawals for retirement from your 401K, you’ll be taxed at your tax bracket at that time. This is great news if your tax bracket is substantially lower when you retire than it is now.
This could save you even more cash on taxes – because, yeah, they already take enough of those, right?
It gets even better when your employers match your 401K contributions. Of course, not all of them can, but if you’re lucky enough to have an employer who does you definitely should take advantage of their generosity. Free money!
What If I Can’t Get A 401(K)?
If you’re self-employed, a freelancer, or your employer doesn’t offer a 401(K) option, don’t despair.
Fortunately, you can set up a retirement fund on your own. And this is a good idea in some cases even if you do have a 401K. Meet the Individual Retirement Account (IRA.)
This leads to a host of new questions like, what is an IRA? Why should I get an IRA? What are the rules about IRAs?
While I can’t cover all the information about an IRAs in this article, I’ve got some cliff notes for you.
The benefits between the two are comparable when it comes to taxes and savings, which are obvious benefits. But they offer some more attractive benefits than 401(K)s – particularly a broader selection of investment options and lower fees.
IRAs also have a few downsides, like lower contribution limits and restrictions for higher earners.
401(k) Contribution Limits
Individuals can contribute up to $19,500 a year or $26,000 if you’re 50 or older. However, those limits only apply to what you personally contribute. Those figures do not include the contribution limits if your employer chooses to match.
In 2020, if your employer matches, you can contribute (combined) up to $57,000 per year to your 401K. $$63,000 if you’re 50 years or older.
This means your employer could match 100% of your contributions and you still wouldn’t hit that limit in a year – which is phenomenal news!
You can also contribute to a 401K and an IRA at the same time – as long as both of them are within contribution limits. And if you happen to have Scrooge McDuckian levels of cash to throw down on both and come even close to hitting those limits, then good on you.
But for the rest of us ninety-nine percenters? You can rest assured that there’s almost no way to hit 401(K) limits if you have any bills to speak of.
Withdrawing Money From 401(k)
Whenever you withdraw from your 401(K), that money is taxed before you receive it. Unless you’re taking out a loan – kind of – but we’ll get to that part later.
If you withdraw funds from your 401K before you reach age 59 ½, you’ll be hit with a 10% early withdrawal penalty fee. If you wait until 59 ½, you won’t be hit with the penalty fee – but you’ll still be taxed.
By age 72, you’ll be forced to take required minimum distributions (RMDs) from your 401K. Previously the RMD was for 70 ½, but the Secure Act in December 2019 now makes it 72.
If at 72 you’re still working, you don’t have to take the RMDs from your plan at your current employer. You will, however, need to start taking RMDs from a 401(K) that a previous employer still has.
This usually only applies if you weren’t forced to cash out or decided not to roll it over to your current employer.
If you need the cash but can’t (or don’t want to) apply for a bank loan, you can take out a 401K loan. If your plan allows it, that is, because not all plans do.
When you borrow from your 401(K), you sign a loan agreement just like you would with a bank. It spells out the principle, terms of the loan, the interest, and any fees or other terms that apply.
You may have to wait a while for the loan to be approved. And even longer for the check to be mailed to you. But, in most cases, you’ll be approved for the loan. After all, it is a loan from you to you.
The IRS limits the amount of money you can borrow at less than $50,000 or half the amount you have vested in the plan. This means if your employer contributed to your plan, not all of the money that’s in your account will be available for you to borrow.
Generally, the vesting period is six to 12 months long. These rules could substantially reduce the amount you can take. Normally, the money you (personally) invest is 100% vested from day one. But sometimes there is a vesting period on that as well depending on your plan.
The max loan term of a 401(K) is 5 years. That’s the longest repayment period that the government allows. If you prefer a shorter term, you should have no problem arranging that, and you can always pay your loan off early.
The only exception to the repayment term occurs if you’re using the money to buy a primary residence. IE: home you’ll be living in full-time. If that’s the case, some plans allow you to borrow for up to 25 years like a traditional mortgage.
If you’re married, your plan may require your spouse to agree in writing to your 401(K) loan. Yeah, I know, it sounds dumb.
But it’s because your spouse may have a right to a portion of your retirement assets if you divorce. If you borrow, change jobs and don’t repay, that money may be gone. And your spouse’s share will be affected if you divorce.
That’s a lot of if’s, but that’s the way it works.
401(K) Loan Downsides
- The money you withdraw will not generate compound interest.
- Repayments are made with after-tax dollars, meaning those dollars you borrow will be taxed twice by the time you retire. If your tax bracket is 10%, you lose $200 for every $1,000 you borrow. And since a 10% tax bracket only applies to those who make under $9,876 and the fees and penalties aren’t included above, expect to lose some serious cash in the long run.
- The fees you pay to arrange the loan will (usually) be higher than a conventional loan. If you have good credit, 401(K) loans are not your best option.
- The interest is never deductible – even if you use that money to buy or renovate your home. So you lose some big tax benefits that come with a home loan.
What Happens To Your 401(K) When You Leave Your Job?
If you have a substantial amount of money, most plans allow you to leave your account with your previous employer.
However, if you have a smaller amount of cash, say $1,000, then you might have to take it with you. Some companies even force you to cash out if it’s below a certain amount.
If you’re going to a new employer, see if they offer 401(K) option and you can roll it over to them. That way you don’t have to pay the taxes, and you don’t have to keep it with your previous employer.
Again, this may not be possible if your employer or your 401K plan forces you to cash out your current 401K balance.
If you’re forced to cash out your current 401(K)’s balance with your previous employer, and your new employer doesn’t offer 401Ks, the best chance you have is to put the money into a Roth IRA. Now, it’s not ideal because, in most cases, you end up being taxed several times on your retirement dollars.
But it may be the best option you have in an unideal scenario.
Post-Retirement 401(k) Withdrawals
We already kinda touched on this, but it’s worth noting again. If you’re over 49 1/2, you can start taking withdrawals from your 401K without the additional 10% penalty.
However, it’s not the best option if you’re still employed and working.
This is because your tax bracket will likely be much higher now than it will be when you’re no longer working. So your retirement dollars will be taxed at a higher tax bracket if you withdraw early.
However, if you’re not working, this is an option to help either get you through or start your retirement early.
Additionally, if you’re between 55 and 59 1/2 , you can still avoid the early withdrawal penalty if you just left your previous employer. For example, if you’re now unemployed, but you had a decent 401K with your previous employer that you just left, you can start withdrawing money now without incurring the 10% penalty.
However, this only applies to recently left employers. This doesn’t apply with employers you left, say, a year ago.
By age 72, if you’re not working, you’re going to be forced to take distributions from your 401K these are called RMD. The age for RMD’s used to be 70 and 1/2, but with new guidelines in place it’s now raised to 72 or you will be forced to take contributions from your 401K.
This only applies if you are not working, or you’re no longer working at an employer where you have an active 401K.
If you have several 401K plans from several employers, but are only currently employed at one of those employers, you only have to take RMDs from the inactive 401(K)s with previous employers.
Traditional 401(k) vs. Roth 401(k)
Traditional 401(K)s are taxed when you take the money out. Roth 401(K)s are taxed when you put the money in. So the big difference is when you’re taxed.
And if all things were equal, it wouldn’t matter when you pay the taxes. Let’s go through an example real quick:
Joe put $7,000 into his Traditional 401(K). That amount triples by the time he retires. Now he has $21,000 saved up and he decides to cash that out. The $21,000 is taxed at 30%, so now he has $14,700.
Sarah puts $7,000 into her Roth 401(K). However, that $70.00 is taxed at 30% when she puts it in. So she actually ends up putting in $4,900. That amount – like Joe’s – also triples. So when she goes to retire, she has $14,700 she can withdraw from her 401K.
So on face value, there isn’t much of a difference. But it only applies if you expect absolutely no material change to your income or tax bracket between your working years in retirement. It won’t make a difference whether you choose a 401(K) or a Roth 401(K).
When To Go Traditional
However, if you expect your tax rate to decrease as you come towards retirement age, then it makes more sense to contribute to a Traditional 401K. Since you’re not being taxed now, and you’ll be taxed later at a much lower tax bracket when you go to withdraw your funds, you’ll get more money this way.
Let’s go back to Joe and Sarah.
Say they’re both taxed at 30% when they contribute, but when they retire, they’re both taxed at 22%. Sarah would still have her $14,700. But Joe would have $18,480.
When To Go Roth
If you expect that your tax rate will increase when you come towards retirement age, it makes more sense to contribute to a Roth 401K. Since you’re being taxed now at a lower tax bracket, you’ll be paying your taxes ahead of time and not have to deal with higher tax rates in the future.
Joe and Sarah are both taxed at 30% when they contribute, but when they go to retire, they’re both taxed at 37% – for some crazy reason. Anyway, Sarah’s Roth 401(K) would net her the same $14,700, but Joe’s would net him $13,230.
What If You Don’t Know?
Of course, the problem with this is that you have to be a good predictor of the future. Which, historically, humans aren’t great at that.
If you are leaning towards even expecting higher tax brackets in the future due to inflation, then it would be safer to go with a Roth 401(K). If you expect your taxes to be about equal or slightly different, it makes more sense still to go with the Roth 401(K).
Unfortunately, most employers don’t author offer Roth. They offer traditional. But if your employer does offer a Roth, they tend to be the better option for most people. Unless you expect some drastic tax change by the time you retire.