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Get the Most Out of Your 401(k) Retirement Plan

Get the Most Out of Your 401(k) Retirement Plan

Jenius Bank Team7/20/2023 • Updated 4/4/2024
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A 401(k) could help your retirement savings grow more over time.

Saving for retirement is something everyone should do, but nearly 55% of working Americans don’t have as much saved up as they should.

That’s why taking advantage of a 401(k) plan through your workplace could be a good idea. But even if you’ve contributed to your 401(k) account for years, you may not fully understand how the account works or how to take advantage of all the benefits they offer.

Here’s what you need to know about these retirement accounts and steps you could take to maximize your savings and prepare for retirement long before you’re ready to exit the workforce.

Key Takeaways

  • 401(k)s could help you build your retirement savings more quickly through strategic investments.

  • These accounts are sponsored by employers and could be rolled over to a new 401(k) or into an IRA if you change employers.

  • Taking money from the account before turning 59 ½ could result in costly fees and penalties.

What is a 401(k) and How Does It Work?

Simply put, a 401(k) is an employer-sponsored retirement account that you’re able to contribute to with each paycheck you receive. These accounts let you invest money into managed funds that could earn returns and grow your savings over time.

Most plans let you contribute a portion (usually a set percentage) of your income automatically from each paycheck. That percentage goes into your 401(k) where it’s invested based on your chosen holdings and allocations.

Over time, your account’s value could increase based on the performance of the funds you invest in.

Employer Contributions

401(k)s are different from Individual Retirement Accounts (IRAs) in that both you and your employer are able to contribute to the 401(k) account.

Many companies offer employer matching contributions as part of your total compensation, meaning they’ll match a certain percentage or dollar amount of contributions you make to your 401(k) each year.

Employer contributions may allow you to build your retirement savings faster, and the sooner you start, the larger your retirement fund may be by the time you need it.

For example, let’s say you’re 25 years old and make $100,000 annually and you start contributing 5% of your salary to a 401(k) each year. Now assume your salary is unchanged over the years and you continue contributing $5,000 per year to the account. With an average rate of return of 7%, you’d have approximately $1,068,048 saved by the time you reach 65 years of age.1

Now, if your employer were to match all your contributions, the total annual contributions to your 401(k) account would be $10,000 instead of $5,000. With all the same assumptions, you’d have approximately $2,136,096 by the time you’re 65.2

Again, this is a rough illustration of the potential benefit of matching; note that these numbers don’t consider any pay raises, increases in contributions, job changes, or taxes when you withdraw the funds. But the point is that employee matching may be something worth investigating through your employer.

Types of 401(k)s

The term 401(k) comes from the Internal Revenue code Section 401(k) which details the regulations that allow employees to avoid paying tax on money set aside for retirement, otherwise known as “deferred compensation”.

Since these accounts allow you to save for retirement without having to pay taxes on the money you save upfront, the original providers of these accounts chose to name them after the IRS code.

There are three main types of 401(k)s that people tend to open:

  • Traditional 401(k): Traditional 401(k)s are what most employers offer. When you contribute, your contributions are made on a pre-tax basis. You won’t owe taxes on the earnings until you withdraw the money which is why we call 401(k)s tax-deferred accounts. You only pay taxes on a traditional 401(k) when you start taking distributions. When you take a distribution, the funds are taxed as part of your income for the year you withdrew the funds. If you withdraw funds before meeting the minimum age requirement, currently 59 ½, you may be subject to an early withdrawal penalty.

  • Roth 401(k): Roth 401(k) accounts are also offered through employers and use contributions that are made with after-tax dollars. The funds grow in your account on a tax-free basis, and since you’ve already paid tax on the money you contribute. You won’t owe income tax when you start taking distributions, and you won’t be subject to any penalties as long as you’ve met the withdrawal requirements of being at least 59 ½ and the account is at least five years old.

  • SIMPLE 401(k): The SIMPLE 401(k) is a retirement account designed for small business owners with fewer employees. To qualify for these plans, employees must work for the employer for at least one year before they may open an account. As with traditional 401(k) accounts, you pay taxes on distributions from your SIMPLE 401(k) and if you take an early withdrawal, you may have to pay a 10% penalty on what you withdraw.

The type of 401(k) that you are able to open largely depends on what your employer offers and what you qualify for. Given choices, your personal tax goals are definitely part of the decision making process. All three are designed to help you save money for retirement while letting you take advantage of certain tax benefits.

401(k) Contribution Limits

There are limits to how much you’re able to contribute to a 401(k) account each year. These contribution limits are set by the IRS and usually change from year-to-year based on cost-of-living adjustments. Your employer’s contributions don’t count toward your individual contribution limit.

In 2023, you are able to collectively contribute up to $22,500 to your 401(k) accounts. This means if you have a Roth 401(k) and a traditional 401(k), you can’t contribute more than $22,500 between the two accounts.3

The IRS allows individuals closer to retirement age to make catch-up contributions until they retire without any penalty. If you’re over the age of 50 and want to put more money away for retirement you are able to take advantage of these contributions, which is $7,500 for 2023.4

So, what happens if you contribute too much toward your traditional 401(k) in a given year? The IRS expects you to pay taxes on the amount you contribute over the maximum amount.

If you report your overage before taxes are due for the year, the amount you contributed over the limit is added to your taxable income for the year. Your plan administrator should also send you a check for the amount that you contributed over the limit.

Overcontributing to your 401(k) is a tricky situation. To make sure you handle the situation correctly, connect with your benefits manager to get everything sorted out properly.

How do 401(k)s Grow?

As you contribute to your 401(k), this money is invested into funds that you or your employer choose when setting up the accounts. These funds are typically a mix of mutual funds, stocks, and bonds.

Many account holders choose to enroll in target date funds. These funds are designed to maximize your investment and growth potential based on a projected retirement date. The goal of these funds is to let you automate your investments, so you won’t have to worry about keeping track of market performance or changing your investment strategy as you get older.

The exact investment options vary based on who is managing your 401(k), but you’re usually able to choose which investment options you want to focus on, which ones you want to avoid, and which you want to try out once your account is set up.

Can 401(k)s Lose Money?

It’s important to remember that 401(k)s are investment accounts. This means that like any investment, there is risk. You as the account holder should determine how much risk you are comfortable with and allocate your 401(k) funds accordingly.

If you’re a “high risk, high reward” type of person, you may choose funds that are oriented toward emerging technologies, for example. However, if the roller coaster of the stock market gives you heartburn, you may want to lean towards corporate and government bonds. Check in with your investment advisor to choose the approach that fits best with you and your goals.

Overall, your 401(k) should be considered a long-term investment… something you start early, contribute to throughout your career, and use in your retirement. Even with market downturns, many have found the 401(k) to be a good strategy to help build wealth and create security for retirement.

401(k) Withdrawal Rules

The point of a 401(k) is to help you save for retirement and the IRS expects you to leave your money in the account until you reach 59 ½ years of age or satisfy other criteria, like being unable to work due to a disability.

But that doesn’t mean you aren’t able to withdraw funds early. It just comes at a price.

If you’re thinking of withdrawing money before you reach 59 ½, and don’t meet other criteria that would qualify you for a fee-free withdrawal, you may have to pay a 10% penalty tax each time you make a withdrawal.

Another way to use your 401(k) is to take out a loan against its value. These loans usually allow you to cover whatever expenses you see fit. But if you choose to take out a 401(k) loan, make sure you understand how the loan and the repayment work. And, of course, prior to repayment, those funds aren’t growing in your 401(k).

401(k)s and Job Changes

Since your employer sponsors your 401(k), it stands to reason that your account changes if you leave your current job.

When you leave your job, you usually have a few options for managing your 401(k). Let’s take a closer look:

  • Leave it with your previous employer’s plan: You may be able to leave your 401(k) with your former employer. If you do, you won’t be able to make contributions to that account anymore, but you are still able to contribute to your new employer’s retirement plan. You would just have multiple 401(k)s to manage.

  • Move it to your new employer’s plan: If your new employer offers a 401(k) plan, you could roll your old 401(k) into the new plan and make additional contributions with each paycheck. Rolling funds over to a new employer’s 401(k) plan isn’t considered a withdrawal in most cases, meaning you usually won’t owe taxes on the rolled over funds when moving them as long as you follow the instructions.

  • Roll it into an IRA: You could roll your current 401(k) into a traditional IRA or a Roth IRA. If you choose to roll a 401(k) into a Roth IRA, it would be considered a “Roth conversion” and you would be required to report the money as gross income for the year the conversion was made. Since it is part of your income, you are required to pay income tax on it.5 IRAs have lower contribution limits, so you won’t be able to save as much each year, but you may be able to continue contributing funds and have them grow tax-deferred or tax-free, depending on the type of IRA you choose.

  • Withdraw the money: You’re not required to roll your account into a new retirement savings account. In fact, you could withdraw the full amount early and use the funds as you see fit. Just remember that early withdrawal penalties and taxes may apply depending on your age, the circumstances, and the account type.

As you can see, there are several options for your 401(k) if you’re changing employers. If you aren’t sure which makes the most sense for you, consult a financial advisor.

Getting the Most out of Your 401(k) in John’s Words

“I have always told my kids that there are four steps to 401(k) optimization,” Jenius Bank president John Rosenfeld says.

The four steps he suggests are:

  • Save Something. Save as much as you are able to while still managing your cost of living

  • Increase Contributions. Try to increase your contributions every time you realize an increase in compensation.

  • Employer Match. Try to get to a point where you are taking full advantage of your employer’s match.

  • Federal Limits. Contribute to the maximum allowed by federal limits.

“Some people think that once you get your employer’s match, there’s not much benefit in going above that, but there are few savings vehicles available that let you save money on a pre-tax benefit, so ideally you could take full advantage of those, before saving after-tax money,” John says.

Final Thoughts

Opening a 401(k) could be a great way to boost your retirement savings and grow your wealth over time.

Though these accounts have some limitations, they’re still a great way to start saving for retirement. Additionally, many employers use 401(k) matching as part of your total compensation package, which is money you’re entitled to!

If you choose to invest in a 401(k), remember to keep contribution limits and age requirements in mind so you don’t risk paying penalties.