401(K) Basics. Here Are 5 Things To Know

401(K) Basics

I had the privilege of spending a portion of my Friday afternoon talking about personal finance. This include 401(K)s. What a great way to wind down the week.

I quickly realized that this is an area that can be overwhelming for many people. There is a ton of information, too much to sift thru and its also complex – pre-tax, after-tax, tax-free, tax-deferred, contributions, etc. Wow !

Our discussion was about what benefits our company offered for our employees.  We covered the basics like 401K, ROTH IRAs & even areas like Health Savings Accounts (HSA) & Employee Stock Purchase Plans (ESPP).

While the benefits differ by employer, I thought it was a great opportunity to talk about the basics of each.

What Is A 401(K) Plan

A 401(K) plan (named for the tax code) was introduced in the late 1970’s, and has grown to be the most popular type of employer/company sponsored retirement plan in the United States.  It allows employees to save and invest a portion of their paycheck (pre-tax) and invest it for retirement purposes.  Millions of employees depend on the month they have saved to fund their retirement years.  401(K) plans come with a great set of benefits – tax-deferred savings, potential tax benefits and company matching programs.

Contribution Limits

A 401(K) plan is a great tool for retirement planning. However, the IRS does put limits on the amount of money you can defer to a 401(K) plan. This is a contribution limits.  For 2018, the maximum amount of compensation an employee can defer to a 401(K) plan is $18,500. Contribution limits often change year to year and other provisions to be mindful of (e.g. catch up contributions limits for employees over 50)  I would recommend you review any changes on the IRS website.

Company Matching Rates

Many employers offer a matching rate for any contributions made to a 401(K) account.  Company matching is an incentive that employers have to match your contributions.  A company that matches at 50% would contribute $0.50 for every $1.00 you contributed. If a company matched at 100%, then they would match $1.00 for every $1.00 you invested. This instantly gives you a boost with you retirement savings!

Company Matching Limits

Many companies place a limit on the amount of money they will match. In other words place a limit on the percentage of salary you can contribute to a 401(K) plan that will receive matching funds.  Most companies I read about limit contributions around 5%.  This will depend on the company. As an example, if you earned $100,000 per year and your company matched 50% of your contributions up to 5% of your salary here is how it would work.  You would receive $0.50 for every $1.00 you invested up to $5,000 (5% of $100,000).  You can continue to contribute to your 401(K) up to the contribution limit of $18,500 but those additional contributions would not be matched.

Distribution Rules

The distribution rules for 401(K) plans are areas to read closely. Contributions within a 401(K) are tax-deferred.  There are rules that apply to when these contributions can be withdrawn.  Currently 401(K) assets can be withdrew when one of the following occurs:

• The participant dies, becomes disabled, or otherwise has a severance from employment.
• The plan terminates and no successor defined contribution plan is established or maintained by the employer.
• The participant reaches age 59½ or incurs a financial hardship. Hardship distributions requirements are listed here.

There are required minimum distributions for 401(K) plans in most situations. There are great resources on the IRS website.

Sure, there are plenty of things to think about when it comes to personal finance and the market. Remember the most important thing is to start now and take advantage of the 8th wonder of the world, compound interest.

Remember that life is a game never won or lost, only played.