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Erica Zimmer:

When it comes to saving for retirement, you've got options. There are many types of investment accounts designed for retirement planning. In this video, we'll explore 401(k) plans. There are several types of these plans, and they're all designed with tax advantages that offer incentives to save for the future.

We're going to focus on one of the most popular, the traditional 401(k). In fact, when people refer to 401(k)s without specifying the type, they usually mean traditional 401(k)s. So that's how we'll talk about them here. So what makes a 401(k) unique, and how can you use one to save for the future?

A company establishes a plan, and its employees can elect to participate or not. When you contribute to your 401(k), the money comes out of your paycheck pretax. You'll eventually pay taxes on the money you've invested and earned, but not until you withdraw it during retirement. So why wait to pay those taxes?

First, it reduces your taxable income for the current year, which, in turn, reduces your income tax. Second, if you expect your earnings to be less in your retirement years than they are today, you may be withdrawing your money while you are in a lower tax bracket, thereby paying a lower tax rate. Another advantage is the relatively high annual contribution limit. As of 2023, the limit is $22,500.

And if you're age 50 or older, there is a catch-up provision that bumps this limit up to $30,000. In contrast, the limit for IRAs is $6,500 for anyone under age 50 or $7,500 for those 50 and older. Finally, many employers sweeten the deal by offering a matching program. For every dollar you contribute up to a certain limit, your employer will add that same amount to your account.

This is essentially a bonus from your company. Now let's look at some of the factors you need to consider when establishing a 401(k). As with any retirement account, a 401(k) is simply a vehicle to invest your money. Compared with some other retirement accounts, 401(k) plans have a limited number of investment vehicles you can choose from - typically, mutual funds, ETFs, and sometimes stock in your own company. So you'll need to factor the specific investment options into your decision-making process. It's also important to remember that these plans are employer-sponsored. So if you leave your company before you retire, you'll need to make sure you have a plan for your 401(k) assets.

While some employers will allow you to keep your retirement savings in their program, others will expect you to take your money with you when you go. If you cash out before you turn age 59 and 1/2, you'll be subject to an early withdrawal penalty of 10%, in addition to any applicable taxes. To avoid them, you can roll over your old 401(k) into a new retirement account, either a 401(k) with your new employer or a traditional IRA.

Penalty-free withdrawals can be made after you turn age 59 and 1/2 but are not required. As of 2023, you are required to withdraw a minimum amount annually when you turn 73, with some exceptions. This is often referred to as an RMD, or a required minimum distribution. If you don't take the annual RMD, you'll pay a hefty nonpayment penalty of 25%.

So to recap, contributions are made pretax, and they grow tax-deferred. You reduce your current taxable income and only pay taxes on investments and earnings when you withdraw that money. Many employers offer matching contributions. If you leave your company before you retire, don't forget to roll your 401(k) into a new retirement account if required.

Penalty-free withdrawals can be made after age 59 and 1/2 but are not mandatory. However, unless you're still working for the employer who sponsors your plan, required minimum distributions must occur annually starting at age 73 to avoid a nonpayment penalty.

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