Your Guide to 401(k) Plans

Companies that offer retirement plans for their employees usually do so through a 401(k) plan. These plans are a great way to save for retirement, and you can increase your benefits if an employer matches your contributions.

Let’s take a look at what 401(k) plans are, how to make the most of them, and what your options are when saving for retirement.

What Is a 401(k)?

A 401(k) is a tax advantaged way of saving for retirement by diverting some of your paycheck into your 401(k) retirement fund. Its name comes from the subsection of the U.S. Internal Revenue Code that regulates this kind of retirement planning.

These 401(k) plans have become increasingly popular in the private sector since early 1980s and many employers offer them instead of pension plans.

One of the main advantages to a 401(k) is that it’s like a tax-free savings account. Whatever you contribute to your 401(k) is tax-free and deducted from your paycheck—although you will have to pay taxes on the funds you withdraw during retirement.

When taking a new job, or at the start of every fiscal year, you can choose the percentage that you want deducted from your regular paychecks and contributed to your 401(k) fund.
Your employer will likely have a couple of options for how you want your 401(k) invested, which is similar to choosing a mutual fund. Your choices may include large cap stocks, bonds, foreign stocks, etc.

Many employers also offer to match a percentage of their employee contributions. Some employers allow you to join the company 401(k) plan within a certain number of days or months after you start.

What Is Vesting for a 401(k)?

Vesting refers to your ownership of your employer’s contributions to your 401(k) account. While you have 100% ownership of your own contributions, you may have to wait a while before you completely “own” your employer’s contributions.

For example, if you would be completely “vested” after two years of working for a company, and you left the company before your two-year anniversary, the company would take back all or a portion of its own contributions to your account. You would still keep whatever you contributed, and the interest you’ve earned.

Some employers allow full vesting within a certain time period. Others do this on a percentage basis, such as being 0% vested within your first year and gaining 20% vesting for each year after that. Under this scenario, if you left a company after three years you would be 40% vested in your 401(k).

Traditional 401(k)s Versus Roth

There are two kinds of 401(k) plans, the traditional 401(k) and Roth 401(k)s. The main difference is with a traditional 401(k), all employee contributions are pretax which means you don’t have to pay federal income taxes on them. You will have to pay taxes on your 401(k) withdrawals during retirement.

With Roth 401(k) plans, all of your contributions are made with your after-tax income, so it’s treated just like the rest of your paycheck as far as taxes are concerned. However, any qualified distributions (withdrawals) that you make from your Roth 401(k) during retirement are tax-free, including your investment earnings.

One of the key reasons why someone might choose either option is their financial expectations during retirement. Someone who expects to be in one of the lower tax brackets when they retire might choose a traditional 401(k) because it offers an immediate tax break on whatever they set aside for retirement.

Someone who expects to be in a higher tax bracket during retirement might choose a Roth 401(k) so they can avoid paying taxes on this retirement income later on.
Simply put, with a regular 401(k) you save money on your taxes immediately and with a Roth 401(k) you save money on taxes when you retire.

A 401(k) makes money just like a mutual fund or an IRA, by investing in things like stocks, bonds, and other securities. Your 401(k) account grows over time because of compound interest, where the interest you earn is added to your account balance so you’re earning money on your own contributions and the growth within your 401(k) fund.

 

IRA Versus 401(k)

While 401(k) plans and individual retirement accounts (IRAs) are both ways of saving for retirement, they’re quite different. A 401(k) plan is something you obtain through an employer. An IRA account is something you would set up on your own. You can have both, and many people do.

With a 401(k) plan, your options for investing the money are limited by your employer or whomever manages their 401(k) plans. With IRA accounts you have more options for investing your retirement funds.

You also won’t have to pay income taxes on your 401(k) contributions. Your IRA contributions are made with income that you paid taxes on, although you might be able to deduct your IRA contributions from your income taxes, depending on your income and whether you or your spouse are covered by a 401(k) plan. For the 2024 tax year, you can contribute up to $7,000 to your IRA, as well as an extra $1,000 catch-up contribution if you are 50 years old or older.

There are also differences as to when you can access your retirement funds. With a 401(k), you may be to access these retirement funds at age 55. With an IRA you would face a 10% penalty on any funds you withdraw before age 59 ½.

Another key difference between IRAs and 401(k)s is that 401(k)s are not FDIC insured the way savings and checking accounts are. Both traditional IRAs and Roth IRAs can be FDIC insured for up to $250,000 if they are held in deposit accounts at a bank that is FDIC insured.

If you’d like to learn more about IRAs and discuss your financial planning for retirement options, one of our wealth managers can help you choose.

401(k) Contribution Limits

There are limits to how much you can contribute to your 401(k) plan, and they often change each year. For 2024 the 401(k) contribution limit is $23,000 and is expected to increase for 2025. Employees who are more than 50 years old can make a “catch-up contribution” of $7,500 although their total 401(k) contributions for the year cannot exceed $69,000.

How Much Should I Contribute to My 401(k)?

How much to contribute to your 401(k) depends on several factors including your employer’s contribution, how much of your income you need right now, and how long you have to save for retirement.

One rule of thumb is to contribute 10% to 15% of your income, or perhaps 20% if you can afford to set that much aside. Keep in mind that investing as much as you can in your 401(k), even at an early age, can have considerable benefits later on as the compound interest grows.

It’s a good idea to at least contribute enough so you get the maximum benefit from any employer matches to your 401(k). If your employer matches your 401(k) contributions for up to 3% of your salary, then contributing at least that much will gain you an additional 3% added to your 401(k) by your employer.

What Happens to Your 401(k) When You Leave Your Job?

If you leave your job for any reason, your 401(k) funds are yours to keep, although you could lose your employer’s contributions if you’re not fully vested in their 401(k) plan. You have a couple of options for what to do with your 401(k) funds.

You can leave the money where it is, although you may have to pay management fees. You could roll it over to your new employer’s 401(k) plan, roll it into a traditional IRA or Roth IRA, or cash out for a lump sum payment. You’ll need to consider these options carefully, as each one offers several pros and cons.

If your 401(k) fund has less than $1,000 in it, your employer may choose to give you a lump sum payment. If your balance is $7,000 or more you could leave your 401(k) funds where they are, although you’d likely have to pay management fees. If you have between $1,000 and $7,000 your employer may choose to convert your 401(k) into an IRA account.

Cashing out Your 401(k)

If you take a lump sum payment or cash out your 401(k) before you’re 59 ½ you would have to pay a 10% early distribution penalty, plus federal and possibly state taxes as well.

Rolling over Your 401(k)

Whether you roll your 401(k) to your own IRA account or your new employer’s 401(k) plan is up to you, although IRA management fees are typically less expensive than those for 401(k) plans.
Here are your options:

• If you roll over your 401(k) funds into your employer’s 401(k) plan, your new 401(k) account would be treated just like any other retirement funds.
• If you roll your 401(k) into a regular IRA, you wouldn’t owe any taxes on it until you withdrew the funds during retirement.
• If you roll your funds into a Roth IRA, you’d have to pay income taxes on these funds, just like you would with your regular Roth IRA contributions.

Withdrawing from Your 401(k)

You can start withdrawing from your 401(k) without penalties as soon as you reach 59 ½ years of age. If you need to tap into these funds before then, you could face financial penalties unless you’re doing so for one of these reasons:

• You leave a job because you become disabled
• Your 401(k) plan is terminated by your company and not replaced
• You experience a financial hardship
• Birth or adoption: Withdraw up to $5,000 per child to meet qualified expenses.
• Disaster recovery: Withdraw up to $22,000 for economic losses during a federally declared disaster.
• Domestic abuse victims can withdraw $10,000 or 50% of their 401(k) account, whichever is lower.
• You can withdraw up to $1,000 per year for personal or family emergency expenses.
• Medical expenses: Withdraw enough to cover any unreimbursed medical expenses that exceed 7.5% of your adjusted gross income.
• Military: If you’re a military reservist who was called to active duty.
• Separation from employment: If you leave your job the same year or after the year you turn 55.

Keep in mind that you you’ll have to pay state and federal income taxes on whatever funds you withdraw, and you would lose any gains in compound interest that you would’ve received if you had left these funds in your account.

The IRS also requires you to begin withdrawing from your 401(k) account once you reach the age of 73.

Borrowing from Your 401(k)

Instead of withdrawing from your 401(k) before retirement, another option would be to borrow from your 401(k) plan instead.
If your employer allows 401(k) loans, the IRS allows individuals to borrow up to $50,000 or half of your 401(k) plan’s balance, whichever is less.
The terms for such a loan would be set by your employer, and you would pay this back through withdrawals from your paychecks on an after-tax basis. The maximum term is typically five years or less, although if you use this loan for a down payment on a residence, the term could be up to 30 years.

The advantages of a 401(k) loan are that they don’t require a credit check, it doesn’t appear on your credit report, and you’re paying interest into your own retirement account rather than a third-party lender.

On the downside, you would lose any compound interest you would’ve gained if you had left your 401(k) funds in your account. If you leave your employer for any reason, you would typically have to pay the loan back immediately or the IRS would treat this as a cash withdrawal, subject to financial penalties.

Discuss Your Retirement Options with a Financial Planner

No matter where you are in your retirement journey, the Wealth Management Team at The First can help with all your financial planning needs. If you’re looking to set up an IRA or rollover your 401(k), we can help you consider all your options and make the best choice. Just contact us or visit one of our convenient Bucks County branches.