Understanding your 401(k) retirement savings plan

When it comes to employer-sponsored retirement plans, 401(k) plans rank among the most popular for those working to build their nest eggs. These qualified cash or deferred arrangements (CODAs), which are permitted under Section 401(k) of the Internal Revenue Code, allow individuals to choose to receive cash payments from their employers immediately or defer a portion of their income in order to pursue their retirement goals. The amount deferred with 401(k) plans is made with pre-tax dollars, and not included in an employee’s income, meaning the individual’s federal taxable income is reduced. Until payments are received from the plan, the deferred portion remains untaxed.

Contributing to your 401(k) retirement savings plan

The start of contributions to a 401(k) plan depends on the terms of the plan outlined by individual employers. Some employees are required to wait up to a year to begin contributing, while other employees experience no waiting period and may begin making contributions as soon as they receive their first paycheck. In many cases, employees are automatically enrolled in a 401(k) plan once they have satisfied the eligibility requirements of the plan.

Currently, individuals can contribute up to $18,000 annually to a 401(k) plan, with those age 50 or older able to contribute up to $24,000. Many employers will match all or part of an employee’s contributions, so it makes sense to begin early and contribute as much as possible to earn the maximum match in order to start working towards retirement savings goals as quickly as possible. To make saving easier, many employees opt to have 401(k) contributions automatically withdrawn from their paychecks.

Those participating in 401(k) plans may also simultaneously contribute to IRAs (both traditional and Roth IRAs). Employees currently may contribute $5,500 to an IRA annually, and that number rises to $6,500 for individuals who are 50 or older.

Early distributions on 401(k) plans

While income taxes are not paid on pretax 401(k) contributions, these contributions and any investment earnings are fully taxable following a distribution from the plan. For those under 59 ½, the taxable amount may be subject to a 10% early distribution penalty.

Should an individual terminate employment, they will generally forfeit any 401(k) contributions that haven’t been vested. Most employees become fully-vested in employer matching contributions after six years of service. Once employment is terminated, those that are fully-vested may choose to take a distribution, which may be taxed; leave the money in the existing 401(k) plan until they reach retirement age or roll the funds into an IRA or another employer’s retirement plan.