A 401K is a tax-qualified retirement-savings-based contribution plan. The contribution made by an employee is matched by the employer in full or partial capacity for the earnings to accrue on a tax-deferred basis.
The earlier you start to contribute on an annual basis, the better will be your savings for retirement. 401K is one of the most popular employer-sponsored retirement savings options. Here are some essential facts about the plan you must know to benefit in the long term.
The current contribution limit for a 401K plan is set at $18500 depending on the type of retirement plan taken, but not everyone can meet this criterion. For a SIMPLE 401K plan, the contribution limit is set at $12,500 for 2018. Factors like employer contribution and taxes should be considered before you can come up with a decent percentage to be set aside for this retirement plan. Also, contributions can be made to your 401K account till you plan to stay employed and the employer matches the percentage to maximize the accrued income.
There is an early withdrawal penalty of 10% for 401K accounts. To avoid this penalty, the earliest you can access your 401K for retirement distribution is when you turn 59 and a half during employment. Retirement distribution is the minimum amount that you must withdraw each year from your retirement savings after completing 59 and a half or 70 and a half in case of continued employment. For early retirement, the age limit is set at 55 years to avoid early withdrawal penalty. The penalty can also be avoided when you retire early due to any disability.
Retirement distribution is treated as taxable income by the IRS after retirement. One of the biggest benefits of the 401K plan is pre-tax contributions that can be made to the account that reduces your taxable income. However, the amount is taxable after you have attained the age of 59 and a half, making retirement distribution withdrawal mandatory.
Expense ratio is one of the important factors to be looked into since a popular misconception is that you don’t pay anything for funds invested in your 401K plan. You might not even notice and end up paying a higher percentage charged by the fund manager for maintaining the said retirement fund. As the money saved up in your fund compounds, so will the fees charged, which can add up to almost 30% of the retirement portfolio. For example, if you have $500,000 in a fund with a 1% expense ratio, you will end up paying $5,000 fees for that particular year. As more money accumulates, the expense ratio will simultaneously increase.
For the first year of retirement, a minimum of 4% of the total balance should be withdrawn to sustain the 401K account balance thereafter. However, the cost of living has gone up significantly in the last decade, making the 4% withdrawal limit insufficient to meet basic expenses. Contribute in a planned manner annually and start early so that you don’t have to overdraw more than what is needed to manage your expenses post retirement.