Invest in Your Retirement Today and Leave a Legacy For Future Generations
At some point in your 20s (or maybe not until your 30s), conversation among your colleagues might shift from what happened during the big game over the weekend to which stock options everyone is eyeballing—and how much they’re investing in their 401(k)s. If you’re starting to feel left behind, now is a great time to learn what 401(k)s are and why they’re crucial for a comfortable retirement.
When you get a new job that offers an employer-sponsored retirement plan—or your company expands its benefits package to include a 401(k)—you're immediately eligible for life-changing investment options with substantial tax benefits. The biggest perk? The money you invest now will grow tax-free until retirement. (There are additional tax advantages spelled out below.)
Human resources will guide you through opting into (or out of) a 401(k) plan. They’ll also help you set up your monthly contribution amount and let you know about your investment options—but the support usually stops there.
We're here to fill in the gaps and help you get the most out of your retirement plans so you can enjoy your golden years and leave a legacy for future generations—even if retirement is still decades away.
Here's everything you need to know about 401(k)s:
What is a 401(k) Plan?
A 401(k)—a defined contribution plan—is a tax-advantaged retirement savings plan sponsored by an employer. The benefits are significant:
It's hassle-free.
Employers often match contributions (free money!).
You set yourself up for a better tomorrow.
Contribution Limits: In 2022, you can contribute a total of $20,500 to your 401(k) plans if you are under 50—and an additional $6,500 catch-up contribution if you're over 50. The overall limit (including employer matching and after-tax contributions) for 2022 is $57,000 if you're under 50—and $63,500 if you're over 50.
Withdrawals: Both traditional and Roth 401(k) owners must be at least 59½ when they start to make withdrawals (or meet other criteria spelled out by the IRS). If you withdraw money early, you may face an additional 10% early-distribution penalty tax on top of any other taxes you owe.
Tip: Don't put all your savings into your 401(k) — make sure you save enough for emergencies and other expenses that may come up before retirement.
Here's everything you need to know about 401(k)s:
What is a traditional 401(k)?
What is a Roth 401(k)?
What are the options for the self-employed?
How do I choose the right retirement plan? Roth 401(k) vs. traditional 401(k)
What is a traditional 401(k)?
If your employer offers a traditional 401(k) retirement plan, you benefit from a lower taxable income and tax-deferred growth on your investments. Here's how it works:
1. It's Hassle-Free and Lowers Your Taxable Income: A percentage of your paycheck is deposited directly into an investment account each pay period before you pay taxes.
In other words, a traditional 401(k) plan allows you to defer a certain percentage of your pre-tax earnings to your 401(k).
2. Employer Match: Your employer may match some or all of your contributions.
Employers who match their employee contributions use various formulas to calculate that match. For instance, an employer may match 50 cents for every dollar the employee contributes up to a certain percentage of salary. Financial advisors often recommend that employees contribute enough money to their 401(k) plans to receive the full employer match.
3. Max Out Your Contributions: When your employer doesn't offer a match (or if the amount is small), you may be able to max out your after-tax contributions.
This option is perfect if you have a high income and are saving a lot of money.
Consider this example: If you're under 50, earn $140,000, and have an employer-sponsored 401(k) plan, you could max out your pre-tax contributions at $20,500 in 2022. If your employer offers a 50% match for up to 6% of your salary, they will contribute an additional $4,200 — bringing your total contributions up to $24,700. Since the overall limit for 2022 is $57,000, you can contribute an extra $32,300 after-tax income to your 401(k) (if your company's plan allows for after-tax contributions).
4. Investment Options: When you invest in your retirement plan, you can choose from a limited number of investment options.
Contributing to your retirement is a great way to dip your toes into the world of investing. Most retirement plans are invested in mutual funds and low-risk target-date funds, designed to reduce risk in the years leading up to retirement.
5. Tax-deferred Growth: Your investment will grow tax-free until you withdraw the money during retirement.
After years of tax-deferred growth, you'll pay income taxes on withdrawals.
What is a Roth 401(k)?
Some employers offer traditional and Roth 401(k)s. While the traditional 401(k) dates back to 1978, the Roth 401(k) is a relative newcomer to the retirement scene (it became available in 2006).
Companies have been relatively slow to add Roth 401(k)s to their benefits package, though more employers are starting to offer both plans. According to consulting firm Willis Towers Watson, 70% of organizations with employer-sponsored retirement plans now have a Roth option.
If your company offers a Roth 401(k), here's how it works:
1. After-Tax Contributions: You pay income tax before contributing to a Roth 401(k).
Your employer will allow you to contribute a specific amount to your Roth 401(k) each pay period, but they will take out taxes first. Essentially, your tax savings are deferred—but the advantages are no less significant (more below in #3).
2. Employer Match: If your employer matches a traditional 401(k), they will likely match your Roth 401(k).
It's standard to offer an employer match for both retirement account options. However, your employer's contributions—and the profits they’ll earn over time—will be taxed when you withdraw money from your account.
3. Tax-Free Withdrawals: You don't pay income taxes when you withdraw from your account.
Alongside tax-free growth, tax-free withdrawal is the main tax advantage of a Roth 401(k): Consider the tax-free growth that can accumulate and compound if you invest while young. And then picture yourself withdrawing money tax-free during retirement. Win-win.
4. More Flexibility and Fewer Penalties: If you've had the account for five years, you can withdraw your contributions from your Roth 401(k) anytime without penalties.
Since you've paid taxes already, the money you put into your plan can be taken out before you reach retirement age. However, if you take out profits earned from your investments, you’ll face early withdrawal penalties. It's not advisable to deplete your retirement fund, but the relative flexibility of a Roth account may give you peace of mind if you're worried about emergencies.
What are the 401(k) options for the self-employed?
The solo 401(k) or individual 401(k) is one of the most popular tax-advantaged retirement accounts for the self-employed. Similar to employer-sponsored 401(k)s, there are traditional and Roth options—and the contribution limits are significantly higher than other common retirement plans for entrepreneurs and independent contractors.
Contribution Limits: In 2022, pre-tax contributions cap out at $20,500 in 2022 for people under 50, with an additional $6,500 catch-up contribution for people over 50. The huge perk of a solo 401(k) is self-employed individuals can contribute as business owners and employees, maxing out their contributions at $57,000 in 2022.
How do I choose the right retirement plan? Roth 401(k) vs. traditional 401(k)
The main difference between a traditional and Roth 401(k) is how they are taxed. Financial advisors often recommend investing in both options since it's impossible to predict tax rates decades out.
When to Invest in a Roth 401(k)
When you invest in a Roth 401(k), you'll pay income taxes upfront — but benefit from tax-free withdrawals during retirement. Remember: All of your contributions will grow over many years tax-free. So if your taxes are low right now — and you expect to be in a higher income bracket during retirement — investing in a Roth 401(k) may be the better option.
When to Invest in a traditional 401(k)
If you expect to make less money during retirement, you may want to save on taxes this year and invest in a traditional 401(k). Alternatively, your reasoning may be purely practical: Suppose your budget is tight, and you have a lot of expenses that you need to cover right now. In that case, you'll save more money on taxes this year with a traditional 401(k).
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