What’s a 401(k)?
It’s a retirement savings plan named after the section of the tax code that authorizes it, and typically offered by for-profit corporations. Those who work for nonprofit organizations may have a similar plan, called a 403(b). Both allow you to contribute regularly to the plan via payroll deduction and to defer paying taxes until you withdraw the money in retirement.
A 401(k) plan offers a menu of investments, typically mutual funds, although some 401(k) plans have a brokerage option that lets you invest in individual stocks. Most plans offer stock, bond and money market funds, as well as funds that invest in all three categories. It’s up to you to decide how to invest your contributions.
What’s so great about a 401(k) for retirement planning?
Quite a few things. Having your contributions taken out regularly is more convenient than having to write a check to banks or investment firms every so often. That makes it more likely that you will continue to save, which makes it more likely you’ll have enough money to retire when the time comes.
But there’s more. Your contributions aren’t counted as income for taxes, which reduces your annual tax bill. For example, if you earn $50,000 a year and contribute $5,000 of your salary to a 401(k), you’ll shelter $5,000 from state and federal income taxes that year. If you’re in the 20 percent combined state and federal tax bracket, that will reduce your tax bill by $1,000.
Your earnings also won’t be taxed until you withdraw them. In a regular brokerage account, you’ll owe taxes on income and capital gains the year in which you receive them. A 401(k) allows your earnings to grow tax-free for as long as you keep the money in your account.
The tax deduction also means that your paycheck won’t be hit as much as it would without a 401(k). If you earn $50,000 a year, for example, you would need to save $417 a month before taxes to have $5,000 saved at the end of a year. If you saved that money in a 401(k), however, you would still contribute $417 a month, but your paycheck would be reduced by just $333 a month, because you’ve reduced your tax bill by more than $83 each month.
And investing regularly gives you the advantage of dollar-cost-averaging, meaning that you buy more shares of your funds when the price is low, and fewer shares when the price is high. Just as a smart shopper buys an extra bag of potato chips when they are on sale, you’re buying more shares of stock when they’re on sale.
What is an employer 401(k) match?
Some companies will also chip in to your 401(k). This is free money, and, as any financial advisor will tell you, free money is good. Suppose, for example, your employer matched every dollar you contributed with 50 cents, up to 5 percent of your salary. If you make $50,000 and save 5 percent, or $2,500, your employer would pitch in $1,250. Even if you earned nothing on your investments, your employer match would mean a 50 percent gain on your contributions — a level that would make hedge-fund managers green with envy.
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What are the 401(k) contribution limits in 2022?
In 2022, you can contribute $20,500 to a 401(k). Those who are 50 years or older can invest $6,500 more, or $27,000. Anything your company contributes is on top of that limit.
There is an upper limit to the combined amount you and your employer can contribute to defined 401(k)s. For those age 49 and under, the limit is $61,000 in 2022, up from $58,000 in 2021. For those 50 and older, the limit is $67,500 in 2022, up from $64,500 in 2021. You can’t contribute more than your earned income in any year.
Can I borrow from my 401(k)?
If your plan allows it, yes. You can borrow up to $50,000 (or 50 percent of your vested balance) from your 401(k). Plans typically allow up to a five-year repayment period. You’ll pay interest on the loan, but you’ll pay it to yourself, rather than the bank.
The drawback: If you lose your job, you’ll have to repay the loan by that year's federal tax deadline. If you don’t, the loan will be considered a withdrawal. You’ll owe taxes on the amount of the loan you didn’t repay. If you are younger than age 59½, you’ll also owe a 10 percent early withdrawal penalty.