Understanding 401(k)s and Retirement

A couple learning about 401(k)s and retirement

Most retirees leave the workforce without a plan of action for how they will use the assets they’ve built up in 401(k)s and retirement accounts. However, considering that retirement can often last for decades, it’s best to clearly understand how the retirement plans operate and how to use them strategically.

What Is a 401(k) Plan? 

A 401(k) is an employee-sponsored retirement account. It typically allows employees to contribute a percentage of their pre-tax salary to the account. Employees often have the opportunity to invest their 401(k) in stocks, bonds, mutual funds, or money market investments. They also dictate the amount of their salary that they want to invest.  

Many employers also offer Roth 401(k) account options, which allow employers to contribute after-tax funds to the retirement account. While this type of 401(k) doesn’t reduce an investor’s taxable income, investors can make withdrawals tax-free after reaching the full retirement age.  

Aside from offering these plans to employers, many companies encourage contributions by offering an employee match. For example, a company might offer to match up to 50% of the first 6% contributed. Under this example, an employee making $100,000 per year can contribute $6,000 to their plan, and their employee will match $3,000. If the employee doesn’t contribute, they don’t get the $3,000. This kind of incentive makes investing in a retirement account attractive for many workers. 

401(k) Contribution Limits 

Each employee decides how much of their income they want to contribute to their 401(k). Contributions are usually a set monthly amount or a percentage of each paycheck. The government limits the amounts workers can contribute to their 401(k) plans for their retirement. The contribution limit for the plan year 2022 is $20,500. Workers over the age of 50 are allowed an additional $6,500 catch-up contribution for a combined contribution of $27,000.  

When Can I Start to Withdraw Money From My 401(k) Account? 

The IRS rules prevent an investor from withdrawing 401(k) funds until they reach the age of 59 ½. Early withdrawals are subject to a 10% penalty and income tax. After turning 59 ½, a retiree can start to take distributions from their account. The IRS rules state that retirees must begin taking distributions from their 401(k) by age 72 (or age 70 ½ if they were born before June 30th, 1949).  

If a retiree has both a Roth and traditional 401(k), they must take required minimum distributions (RMDs). RMDs from a traditional 401(k) are included in taxable income, while RMDs from a Roth 401(k) are not. 

Tax Issues to Consider 

It’s essential to consider the impact of distributions on taxable income. While most retirees find themselves in a lower tax bracket upon leaving the workforce, the amount of their income combined with 401(k) distributions can easily bump them back up into a higher tax bracket. People living on a fixed income in retirement should be particularly mindful of this impact.

There can be a lot of confusion about 401(k)s and retirement. Before setting up a retirement distribution plan, it’s often good to speak with a trustworthy estate or financial planner so you’re not hit with any surprises.  

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