Building Your Nest Egg: 401(k) Explained

Building Your Nest Egg: 401(k) Explained

When most of us think about retiring, it is easy to picture ourselves having a comfortable cash cushion to sit on, but we often experience uncertainty when trying to figure out how to inflate that cushion. Sorting through and understanding retirement options can be a confusing and daunting task. If you are planning for retirement and a 401(k) is available to you, it may be a beneficial option for you to explore. To help you better understand what a 401(k) can do for you, review the following essentials.

What is a 401(k)?

A 401(k) is a tax-deferred retirement plan that is commonly offered by employers as an added benefit to their employees. The name of the retirement plan, 401(k), derives from its section of the Internal Revenue Code, and has become one of the most commonly used employer-sponsored retirement programs.

Putting the Money In

There are multiple ways that a 401(k) can be funded:

Employee contributions

Employee select a tax – deferred dollar amount or percentage of their salary to be placed into their retirement fund.





Non-elective contributions

Employers contribute a specific dollar amount or percentage of the employee’s salary to the employee’s account.




Matching contributions

Employers contribute to the employee’s retirement fund based on a specific formula framed around how much the employee elects to contribute. For example, a common company-match program is 50 cents for every dollar contributed by the employee, up to 6 percent of the total salary deferment.

401(k) plans can be funded by any combination of these three options, though it should be noted that employee contributions of any kind are not required.

Here are additional basics to understand regarding the funding of your 401(k):

Vesting – Many companies establish a vesting schedule that allows employees to gain entitlement to employer contributions as their tenure with the company lengthens. Employees are always 100 hundred percent vested in their own contributions however, as those funds originally belonged to them to begin with.

Contribution limits -Employees are in control of how much they contribute to their 401(k), so long as they stay within the annual contribution limits that are set by the IRS. In 2018, employees under the age of 50 may contribute up to $18,500.

Catch-up contributions – Employees over the age of 50 have the ability to make additional contributions up to a specific limit. In 2018, employees over the age of 50 may contribute up to an additional $6,000.

Investing Your Funds

Once a 401(k) plan has been established, employees may choose where to invest their funds from a list of investment options. Employees may opt for allocation of different percentages to different investments, devote all of their funds to one investment or choose to decline on investing their funds altogether. Investing funds from one’s 401(k) is not risk-free, but it does offer the possibility of portfolio growth.

Taking the Money Out

Funds in your 401(k) account may be available to you should you wish to access them before you retire. However, if you desire to make a withdrawal from your 401(k) prior to retirement and are not in a state of financial hardship, you may be subject to a 10 percent tax penalty in addition to the regular income tax that is due at the time of withdrawal. Because of the negative impact an additional 10 percent would have on your funds, it is widely recommended to avoid withdrawing from your 401(k) unless you believe it is absolutely necessary. It should be noted, however, that there are certain exceptions to the additional 10 percent tax penalty.

It may be possible to use money from your 401(k) before retirement without the 10 percent tax penalty if you need it for sudden disability costs, avoiding eviction or foreclosure, buying your first house, or the expenses of higher education. However, withdrawing from that fund means withdrawing from your future financial stability because you are extracting potential portfolio growth. One way to be sure that the funds you take out are eventually refunded back into your retirement plan is to take out a loan from your 401(k), if this feature is an option in your employer’s 401(k) plan.

Taking a loan from your 401(k) is a lot like most other loans; you have a set amount of time to pay it back, you will be penalized if you don’t pay it back on time (the additional 10 percent tax penalty that comes from making an early withdrawal), and you will owe interest on the loan that is similar to the market rate of other loans. Whether or not a 401(k) loan or another type of loan is a better option varies by each individual scenario, as there are pros and cons to each type of loan. For example, a benefit of borrowing from your 401(k) rather than a different loan is that the interest you pay goes to you, so the interest you pay actually helps fund your future financial stability rather than becoming money that you will never see again. On the other hand, borrowing from your 401(k) plan could significantly reduce the potential growth of your portfolio, as the funds that would normally be invested are no longer in the account.

What is a Roth 401(k)?

The primary difference between the traditional 401(k) discussed above and the Roth 401(k) is that the taxation on the plans is reversed. In other words, funds that are contributed to a traditional 401(k) are not taxed at the time of contribution, but the funds are taxed at the time of withdrawal. Contributions to a Roth 401(k), on the other hand, are taxed with each contribution, but not at the time they are withdrawn. Because each contribution to a Roth 401(k) is already taxed, Roth 401(k) plans are not subject to required minimum distributions (RMDs) like traditional 401(k) plans are. RMDs are annual withdrawals that a tax-deferred plan participant must make once they reach age 70 1⁄2.

If a company offers both a traditional 401(k) and a Roth 401(k), an employee may choose to use either or both of them. Companies that offer both Roth and traditional contributions allow employees to elect what percent of each type of contribution is funded to their retirement plan.

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