A 401(k) can be one of the most important tools you have for building savings for retirement. Here’s how it works and what to know about your options.
For many people, a 401(k) is one of the first steps toward saving for retirement. These employer-sponsored retirement plans allow employees to set aside money from their paychecks and invest it for the future.
Over time, regular contributions and potential investment growth can help build a retirement savings account that may eventually provide income when you stop working.
But understanding how your 401(k) works is important, especially if you change jobs or retire.
What Is a 401(k)?
A 401(k) is an employer-sponsored retirement savings plan that allows employees to contribute a portion of their wages to an individual retirement account.
With a traditional 401(k), contributions are generally made before federal income taxes are applied. The money can then grow within the account without being taxed until it is withdrawn.
Many employers also offer a matching contribution. For example, an employer may contribute a certain amount for every dollar an employee contributes, up to a specified percentage of their pay.
Employer contributions can be an important part of your overall retirement savings. However, employer contributions may be subject to a vesting schedule, meaning you may need to work for the company for a certain amount of time before you fully own those contributions. Your own contributions are always 100% vested.
Traditional 401(k) vs. Roth 401(k)
Depending on your employer’s plan, you may have the option to make traditional 401(k) contributions, Roth 401(k) contributions or both.
Traditional 401(k): Contributions are generally made before federal income taxes. You generally pay taxes when you withdraw the money in retirement.
Roth 401(k): Contributions are made with money that has already been taxed. Qualified withdrawals can generally be made tax-free.
The two options have different tax treatment, so understanding how each works can help you determine how they fit into your retirement strategy.
Why Start Saving Early?
One of the biggest advantages of a 401(k) is having time on your side.
The money you contribute can be invested, and any investment earnings can potentially grow over time. With years or decades until retirement, even relatively small contributions made consistently can add up.
A 401(k) can also make saving easier because contributions are typically made automatically through payroll deductions. Instead of having to remember to transfer money into a retirement account each month, your contribution can come directly from your paycheck.
Some employers also offer automatic enrollment, which allows employees to be enrolled in the plan automatically unless they choose not to participate or change their contribution amount.
What Happens to Your 401(k) When You Leave a Job?
Changing jobs doesn’t mean your retirement savings disappear. When you leave an employer, you generally have several options for your 401(k).
Depending on your circumstances and the rules of your plans, you may be able to:
- Leave the money in your former employer’s plan
- Move the money into your new employer’s retirement plan
- Roll the money into an IRA
- Take the money as a distribution
Each option has different considerations, including investment choices, fees, taxes and how you want to manage your retirement savings.
For example, rolling your money into an IRA can allow you to consolidate retirement savings and may provide different investment options. Moving the money into a new employer’s plan may allow you to keep your retirement savings together with your current workplace account.
You don’t necessarily have to make a decision simply because you’ve changed jobs. Taking time to understand your options can help you determine what makes sense for your situation.
What Is a 401(k) Rollover?
A rollover is when money from one retirement plan is moved into another eligible retirement account, such as an IRA or another employer-sponsored retirement plan.
A properly completed rollover generally allows the money to remain tax-advantaged rather than being treated as a taxable distribution. A direct rollover, where the money moves directly from one plan to another, can help simplify the process and avoid mandatory federal withholding that generally applies when an eligible retirement-plan distribution is paid directly to you.
If you receive the money yourself instead, different rules apply. Generally, you have 60 days to complete an eligible rollover, and retirement-plan distributions paid directly to you are generally subject to 20% federal income tax withholding.
Because retirement plan rules can be complicated, it’s important to understand the tax consequences and requirements before moving money from one account to another.
Don’t Forget About Your Old Retirement Accounts
Changing jobs throughout your career can leave you with multiple retirement accounts from different employers.
It can be easy to lose track of an old 401(k), especially if you haven’t looked at the account in years. Reviewing old retirement accounts periodically can help you understand where your money is, what fees you’re paying, what investment options you have and whether your current strategy still fits your goals.
For some people, consolidating retirement accounts may make their finances easier to manage. For others, keeping money in an employer-sponsored plan may make sense based on the plan’s investment options, fees and other features.
There isn’t one option that works for everyone.
Planning for Retirement Starts With Understanding Your Options
Your 401(k) can play an important role in your long-term financial plan. Whether you’re just starting your first job, changing careers or getting closer to retirement, understanding how your account works can help you make more informed decisions about your money.
If you have an old 401(k) or are considering your retirement options, take the time to review your account and understand the choices available to you.
Key Takeaways
- A 401(k) is an employer-sponsored retirement savings plan that allows you to save through payroll deductions.
- Traditional and Roth 401(k) contributions have different tax treatments.
- Some employers contribute matching funds to employee 401(k) accounts.
- Your own 401(k) contributions are always fully vested, while employer contributions may be subject to vesting rules.
- When you leave a job, you may have several options for your 401(k), including leaving it with your former employer, moving it to a new employer’s plan, rolling it into an IRA or taking a distribution.
- A properly completed rollover can generally allow your retirement savings to continue growing on a tax-advantaged basis.
- Kohler Credit Union can help you explore retirement savings and IRA options as you work toward your long-term financial goals.
*Information in our blog posts are made available to you as self-help tools for your independent use. We cannot and do not guarantee their accuracy, their applicability to your circumstances or guarantee of credit. We encourage you to seek personalized advice from qualified professionals regarding all personal finance issues.