401(k)s Explained

A 401(k) is a retirement plan that allows you to make contributions from your salary that your employer will match. Let’s talk about how 401(k)s work and how you can make the most of them!

What Is a 401(k)?

A 401(k) is a type of retirement account that involves some collaboration on the part of an employee and his or her employer. When an employee enrolls in a 401(k) plan through their job, they choose to have a certain amount of their salary withheld from their paychecks. The employer will coordinate this withholding and usually match a certain amount. By “match,” I mean that the employer will contribute a certain percentage of what you’re contributing out of their own pocket, increasing the amount of money being deposited into your 401(k). Your money, as well as your employer’s match, will go straight to a financial institution that will invest the money for you, usually in a portfolio of target-date funds that you get to choose. Why is this important? Because it’s free money; as long as you contribute part of your salary, you get extra money from your employer. There are very few “free lunches” in the world of finance, and this is one of them. So be sure to take advantage of employer 401(k) matching whenever you can.

How Do Taxes Work for 401(k)s?

IRAs are tax-advantaged, meaning that you get special tax benefits that you wouldn’t otherwise get by investing your money in a regular brokerage account. Firstly, you don’t have to worry about capital gains taxes, or taxes on your stock dividends or bond interest; you only have to worry about income tax. With a traditional 401(k), you defer your taxes to retirement. This means that you take a tax deduction for your contribution, reducing the amount of your taxable income for the current year. When you retire and start withdrawing the money later on, you will pay income tax on it then at the tax bracket you’re in during retirement.

With the increasingly popular Roth 401(k), you make your contributions with after-tax dollars. Instead of taking a tax deduction for the current year and paying the income tax during retirement, you do pay the income tax on your contribution this year and you don’t have to worry about any taxes on your withdrawals in retirement. The rule for choosing between a traditional 401(k) and a Roth 401(k) is the same rule that applies to IRAs: if you plan on being in a higher tax bracket in retirement than the one you’re in now (which generally applies to younger people who are just starting out), go with the Roth. Otherwise, stick with the traditional.

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

Just like other tax-advantaged retirement accounts such as IRAs (individual retirement accounts), the IRS (Internal Revenue Service) sets limits on the amount that employees can contribute to their 401(k)s in any given year. For the year 2021, employees can contribute up to $19,500 of their salary to their 401(k) plans. Employers can match their employees’ contributions by an amount that is no more than 100% of their salary or a total contribution of $58,000. Employees that are 50 years old or older can also make catch-up contributions which increase their overall contribution limits. To learn more about the 401(k) contribution limits for 2021, head over to the IRS website.

How Much of My Contributions Will My Employer Match?

This depends on the employer. Some employers will match your contributions dollar-for-dollar up to a certain percentage of your salary, and then by 50% after that up to a certain percentage of your salary. Other employers will only match your contributions by 50% up to a certain percentage of your salary, requiring you to contribute more in order to obtain the maximum possible matching contribution. For example, it’s typical for employers to offer 50% matching up to 6% of their employees’ pay. So, if you make $100,000 a year, you can contribute $6000 in order to receive the maximum match of $3000. Other employers will simply match your contributions dollar-for-dollar up to 3% of your salary. So, if you make $100,000 a year, you can contribute $3000 in order to receive the maximum match of $3000. You can keep contributing more to your 401(k) after that (up to the maximum contribution limit set by the IRS), but your employer won’t match any more of your contributions after the pre-specified amount.

In both of the above examples, the maximum employer match for 401(k)s comes out to 3% of the employee’s salary. The first example required a higher employee contribution since the employer was only matching 50 cents on the dollar, while the second example required a lower employee contribution because the employer was matching dollar-for-dollar.

Final Thoughts

The national average for employer matching is somewhere around 4% of the employee’s salary, whether this comes in the form of dollar-for-dollar matching, matching a certain percentage of contributions, or a mix between the two. Keep this in mind when you prepare to negotiate your benefits package for your next job, and do the math to make sure that your employer’s total match will come out to an acceptable percentage of your salary!

Want to take even more steps towards setting yourself up for a comfortable retirement? Check out our list of the Best Investing Courses of 2021!