401(k) 101: What is it and how does it work?

The basics behind saving for retirement

A 401(k)* is the most common employer-sponsored retirement plan. It was created in 1978 and named after the section of the tax code that governs this type of plan. If your employer offers a 401(k) as part of their benefits package, you can elect to contribute a percentage of each paycheck into this long-term savings account. The money you invest earns interest over time and uses the power of compounding to build a nest egg so you can feel confident going into retirement!

How does it work?

A 401(k) is a defined-contribution plan, meaning participation is voluntary, employees decide how much to contribute and the final account value is not guaranteed. To get started, you will decide what percentage of your paycheck you’d like to contribute to the plan. Most employees start between 4-6%, but the goal is to put away 10-15% of your paycheck, up to the annual limit. In 2021, the maximum annual limit an employee can contribute is $19,500, and it will increase to $20,500 for 2022. Employees 50 and older can contribute $6,500 more as a “catch-up” contribution. Whatever percentage you select is automatically withdrawn from your pre-tax income and deposited into your retirement account.

Most employers offer to match your contribution as well, helping you to save more faster. Typically, employers will match 50-cents-to-the-dollar or dollar-for-dollar up to a 6% contribution, meaning your money could be doubled each paycheck.

The best part; your money doesn’t just sit there! You can decide how to invest your contributions so your money earns money. Each employer’s plan is different, so they will provide a list of allocation options, like mutual funds or target-date funds, for you to choose from. Target-date funds are common for first-time account owners because the investments are structured to grow based on the year in which you plan to retire, so you aren’t required to manually make changes.

Why should I open an account?

  • A 401(k) boosts your savings power because the money is withdrawn before taxes are taken out. You save the full value of $1 before the IRS jumps in to take its tax cut.
  • Because this is a tax-deferred account, all contributions lower your taxable income. In a way, you’re protecting some income from taxation.
  • Your account gains and dividends grow without being taxed, until you are ready to withdraw at retirement. At that point, the IRS will tax the entire withdrawal amount.
    • Some employers also offer a Roth 401(k), which works similarly to a traditional plan, but all contributions are deducted from your after-tax income. This plan type allows you to pay all income tax in the present, so the final withdrawal is tax-free. The downside is that a Roth 401(K) does not lower your taxable income so you won’t receive annual tax breaks.
  • A 401(k) is transferrable as well. If you change employers, you have the option to withdraw in full (which comes with a 10% penalty fee if you’re below age 59 ½, plus taxes), directly rollover into your new employer’s plan, or rollover into an individual retirement account (IRA). You can leave your account with a former employer, but then you are unable to make more personal contributions and if you do this multiple times, it could leave a trail of forgotten accounts.

Investing in your retirement can seem daunting, but it’s important to start early and save for your future. If you have questions, contact a banking advisor to learn more about First Federal Bank’s IRA, or you can learn at your own pace with our free retirement preparation courses!

*Not insured by the FDIC. Not a deposit or other obligation of, or guaranteed by, the depository institution. Subject to investment risk, including possible loss of the principal amount invested.

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