What to know about 401(k)s - an investment vehicle that can help you to save for retirement

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• A 401(k) plan is an employer-sponsored retirement plan where employees can contribute their pre-tax income, up to a limit, where it can grow tax-free.
• There are two types of 401(k) plans: traditional 401(k) funded with pre-tax dollars and Roth 401(k) plans funded with after-tax dollars.
• It's possible to withdraw money from a 401(k) early, but you'll have to pay taxes and penalties.

Everyone knows it's important to save for retirement. According to a 2020 study by TD Ameritrade, most Americans hope to retire by 67 and more than half have a plan in place to do so. If you're among those who are wondering where to start, you may have considered a 401(k) as an option.

A 401(k) is one of several retirement vehicles that can help you plan for the future. Here's what to know.

What is a 401(k)?

A 401(k) plan is a tax-advantaged retirement account offered by employers in the US. This retirement vehicle is named after Section § 401, subsection k, of the US Internal Revenue Code.

This type of account allows employees to save for retirement by contributing a portion of their income to the account over time. Contributions are made through payroll every pay period. Employees can choose to contribute a percentage of their salary or a fixed amount up to a certain limit. These investment vehicles are tax-advantaged, meaning they lower your taxable income since they're funded with pre-tax money - and the funds in the account grow tax-free.

Some employers contribute to employees' 401(k) plans by offering an employer match. For example, an employer may offer to match an employee's contributions dollar-for-dollar up to the first 5% of the employee's salary.

Quick tip: Find out your employer match rules and contribute enough to your 401(k) to capture the full amount. This is extra money on top of your contribution and will help your retirement account grow faster.

Employer contributions often come with strings attached, such as a vesting schedule. Vesting means employer contributions and earnings on them are not property of the employee until certain conditions are met. Most times, employers require employees to be employed for a defined period before all employer contributions and earnings become the employee's property.

Types of 401(k)s

There are two types of 401(k) plans: traditional 401(k)s and Roth 401(k)s. Not all employers offer both types of 401(k) plans.

Here's how they work:

• Traditional 401(k) plans: Traditional 401(k) plans allow employees to contribute pre-tax dollars to their account, lowering their taxable income. However, withdrawals from the account will be taxed. In general, this type of 401(k) is ideal if you think you'll fall into a lower income tax bracket at retirement when you take taxable distributions.
• Roth 401(k) plans: Roth 401(k) plans are the opposite in that they're funded with after-tax dollars. There's no income tax break when they are funded, but you won't have to pay taxes on withdrawals later on during retirement. Contributions and earnings grow tax-free.

Annual 401(k) contribution limits

For 2021, the maximum amount an employee can contribute to a 401(k) is $19,500. Employees age 50 or older can make a catch-up contribution of $6,500 for a combined total limit of $26,000.

These limits apply to both traditional 401(k) plans and Roth 401(k) plans, even if you split your contributions between the two. If you change employers part way through the year, your total 401(k) contributions cannot exceed this limit.

Another important thing to keep in mind: 401(k) contributions cannot exceed an employee's income. For example, If you make $15,000, you can't contribute $19,500 to your 401(k) plan.

However, employer contributions are not subject to this limit. Overall, employee and employer matching contributions cannot exceed $58,000 (or $64,500 for employees age 50 or older). Some employers allow employees to make after-tax non-Roth contributions, which are subject to this limit.

Here's a quick overview:

Rules for withdrawing money from a 401(k)

If you're looking to withdraw money from a 401(k), keep in mind that there will be taxes - and even fees - to pay, depending on the type of 401(k) you have, your age, and other factors.

Let's look at each scenario where you can withdraw funds before retirement:

How to avoid withdrawal penalties

While 401(k) plans allow your savings to grow until retirement, there are ways to access the money early. Just keep in mind that it will cost you - both in penalties right now and in lost earnings down the road.

Money withdrawn from a 401(k) plan before age 59.5 will be subject to a 20% federal income tax and an additional 10% penalty from the Internal Revenue Service (IRS). This means if you withdraw $5,000, your plan administrator will withhold $1,000 (20%) and you will owe the IRS $500 when you file your taxes, leaving you with $3,500.

While you can't avoid the federal income tax in most cases, there are ways to avoid the 10% penalty in certain situations:

• Permanent disability: If you need to withdraw funds because of a permanent disability, you won't be on the hook for the 10% penalty.
• Asset division during divorce: Funds that need to be withdrawn while dividing assets in a divorce are not subject to the penalty.
• Qualified military reservists: Those called to active duty for at least 180 days can make withdrawals penalty-free.
• Rule of 55: If you leave your job, are laid off or fired at age 55 or older, you can avoid paying the early withdrawal penalty.
• Elect "substantially equal periodic payments": A special provision allows you to withdraw a specific amount from your 401(k) every year for five years or until age 59.5, whichever comes sooner. There are many rules with this option, so it's best to work with a qualified financial advisor.
• Hardship withdrawal: If you can prove to the IRS that you have an immediate and heavy financial need, you may qualify for a hardship withdrawal to pay for qualifying medical expenses or to repair your home after a disaster.
• Upon death: Distributions made to a beneficiary or estate on or after your death are not subject to the penalty.
• IRS taxes: If you owe money to the IRS, you can take a penalty-free withdrawal to pay back Uncle Sam.
• Birth or adoption: You can take up to $5,000 penalty-free to pay for a qualified birth or adoption.
• COVID-related financial hardship: The Coronavirus Aid, Relief, and Economic Security (CARES) Act allowed for withdrawing up to $100,000 out of a 401(k) account penalty free because of financial hardship stemming from the COVID-19 pandemic. This only applies to withdrawals taken out during 2020.
• Plan rollover: If you roll over your account to another retirement plan within a certain time frame, you can avoid the 10% penalty.

Post-retirement rules

Once you reach 59.5 years of age, you can access the money inside your 401(k) account without paying a penalty. Depending on the type of plan you have, you may be on the hook for income taxes on any distributions.

"As a practical matter, most people transfer their 401(k) to an IRA before or during retirement," says Sean Mullaney, CPA and financial planner with Mullaney Financial & Tax. They can choose the financial institution where they roll over the money and will have access to a wider variety of investment options than offered by most 401(k) plans.

Starting at age 72, individuals must start withdrawing required minimum distributions, called RMDs for short, from their 401(k) account. If they still work for an employer at age 72 or older, they will not need to take RMDs. Mullaney says this exception generally does not apply if the employee has a substantial ownership interest in the employer.

How to open a 401(k)

Getting started investing in a 401(k) is fairly simple. You'll need to set up your account with your employer and decide how much of your paycheck you want to contribute each month.

The 401(k) plan administrator offers employees investment options such as mutual funds, index funds, and exchange-traded funds. You can decide which funds to invest in and how much of your contributions to invest in each fund. For example, you can decide to divide your monthly contributions between a total market index fund and a bond index fund.

Investing options vary from plan to plan. It's important to review fund performance and choose funds that align with your risk tolerance and long-term goals.

401(k) loans

Sometimes you may need early access to the funds in your 401(k) if something comes up. In this case, you can take out a loan against your balance, which is known as a 401(k) loan. You can borrow up to 50% of your vested balance or $50,000, whichever is less, while avoiding penalties. You'll have five years to repay the loan, but this may be different depending on your plan rules.

Quick tip: Many people overestimate how long they will be with a company before taking out a 401(k) loan. Always check the rules for 401(k) loans with the plan sponsor and consider how long you will stay at your current company before taking out a loan. This can save you a headache down the road.

The good news is that you won't be depleting your retirement savings permanently and any interest you pay will go back into your 401(k). However, you will be on the hook for origination fees. And if you cannot pay back the loan within the specified time frame, the IRS considers it a distribution, so you will have to pay income tax and the 10% penalty.

If you leave your job, get laid off, or are fired before you repay the loan, the plan sponsor may require that you repay the outstanding balance immediately. If you don't, it may be reported to the IRS as a distribution and subject to federal tax and an early withdrawal penalty.

The financial takeaway

A 401(k) account can be a great way to save for retirement and minimize your tax burden. It allows you to save for retirement in a tax-advantaged way. Since the money is automatically deducted from your paycheck, it makes it easy to save. Many employers also offer a match, helping your retirement savings grow faster. You should always contribute enough to your 401(k) to capture the full employer match every year if you can. This is free money, should you meet the vesting schedule, and is part of your total compensation package.

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