What Is a 401k?
A 401(k) is a retirement savings account offered by for-profit employers to help their employees save for retirement. A 401(k) offers tax breaks for diligently saving for retirement, according to the Internal Revenue Service, but isn't the easiest account to withdraw from if you need money before you retire. Using a 401(k) for your retirement savings increases the growth of your nest egg because no matter what type of 401(k) you use, the money grows without being taxed.
Tax Savings for Using 401(k)
A 401(k) may offer two ways to save. With a traditional 401(k), the money you put into the account doesn't count as taxable income. For example, if you defer $2,000 into your 401(k), your taxable income on your W-2 at the end of the year will be $2,000 less, which makes it function like a tax deduction. But, your withdrawals from a traditional 401(k) count as taxable income. A Roth 401(k), on the other hand, won't reduce your taxable income just by contributing. But when you take your qualified withdrawals in retirement, you won't have to pay any taxes.
Your company decides the investment options available to you after you put your money in the 401(k). You will have at least three, according to the Financial Industry Regulatory Authority, but you may have many more, especially if you work for a larger company. These options can include company stock, mutual funds and, for some companies, a brokerage account where you get to pick individual stocks and bonds on your own.
Annual Contribution Limits
You can contribute up to $17,500 to your 401(k) each year as of 2014, according to the IRS. In addition, unlike an individual retirement account, your employer can make contributions to your 401(k) plan on your behalf. Sometimes, your employer makes a contribution regardless of how much you put in. Other times, your employer may offer to match your contribution up to a certain amount. For example, your employer might put in 50 cents for every dollar you contribute, up to $6,000. The total contributions made between you and your employer can't exceed $53,000.
Taking Your Money Out of a 401(k)
You can only withdraw your 401(k) funds after you turn 59 1/2, you leave your employer or you have a severe financial hardship, says the IRS. However, taking money out before 59 1/2 results in an extra 10 percent tax on the withdrawals unless you have an exemption, such as a permanent disability or you retired after turning 55. But, if your 401(k) allows loans, you can borrow up to $50,000 or half your account balance (whichever is smaller), and repay it over five years from your future paychecks.