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How to Invest in a 401(k)

If your employer offers a 401(k) investment option, it can be a convenient way to save for retirement. Here are the ins and outs of investing in a 401(k) plan.

By Mike Faden | American Express Credit Intel Freelance Contributor

7 Min Read | July 31, 2020 in Life

 

At-A-Glance

401(k) plans are a convenient way to save for retirement – with tax breaks as an incentive – and are offered by many employers.

They have relatively high contribution limits, and many employers contribute additional matching funds.  

Some 401(k) investing rules change starting in 2020: there’s now no age limit on contributions, required withdrawals start at 72, and 401(k) plans are available to more part-time workers.

If you’re an employee looking for the best way to save for retirement, your employer’s 401(k) may be a good – and convenient – option to consider. Many companies offer 401(k) plans as an employee benefit, and millions of people use them to save for retirement. 

 

Like most other types of retirement plans, 401(k) plans reward you for saving by giving you a tax break, either when you contribute or when you withdraw money at retirement. But 401(k) investing also offers other advantages:

  • Convenience: You can generally invest simply by diverting some of your paycheck into the plan.  
  • Employer matching: Many employers kick in matching funds when you invest.  
  • High contribution limits: You can save up to $19,500 in 2020, or $26,000 if you’re over 50, not counting any available employer matching contributions. 

 

Some of the rules for 401(k) investment have changed starting in 2020, as a result of legislation passed in late 2019 (the SECURE Act1). For example, there’s now no age limit for when you can contribute.

 

What Is a 401(k)? 

401(k) plans, named after the section of the tax code that describes them, are retirement plans offered by private-sector for-profit employers. Generally, your employer decides on key features of the 401(k) plan, such as when employees become eligible to contribute and whether the company will contribute matching funds. The employer also chooses a plan provider, which is a financial-services company that administers the plan and offers the plan’s investment options.

 

As an employee, you decide how much to invest and which of the investment options to choose. You may need to sign up for the 401(k) plan before you can contribute, although many companies now enroll employees automatically and may even select default contribution rates and investment options. Most plans let you start contributing as soon as you join the company, but some make you wait as long as a year. 

 

If you’re a part-time employee, the SECURE Act makes it more likely that you’ll be able to invest in a 401(k) plan. The law now requires employers with a 401(k) plan to offer it to any employee who worked more than 1,000 hours in a single year or 500 hours per year for three consecutive years, except in the case of collectively bargained plans (a 401(k) plan with terms negotiated by the employer and a group of employees or a union).

 

How Much Can You Invest in a 401(k)?

The maximum amount you can invest in a 401(k) increases in some years to keep up with inflation. For the 2020 tax year, you can contribute up to $19,500, an increase of $500 over 2019. If you’re 50 or over, you can make additional “catch-up” contributions of up to $6,500 in 2020, raising the total to $26,000. 

 

Thanks to the SECURE Act, you can now continue investing in your 401(k) for as long as you continue working – even if you work well past the traditional retirement age – because the law abolished the previous age limit for contributions of 70½.

 

Your Employer May Also Invest in Your 401(k)

Many employers make matching contributions when employees invest in their 401(k), which provides an additional incentive to save as much as you can. One major plan provider found that roughly half of employers made matching contributions in 2018. In the most common matching formula, employers chipped in 50 cents for every dollar that employees contributed up to 6% of their salary. Some employers based their matching funds on other factors, including employees’ age or how long they’d worked at the company. Some employers also add profit-sharing or other “non-matching” funds that are independent of the employee’s contribution.2 The total limit on the combined employer and employee contributions is $57,000 in 2020, or $63,500 if you’re 50 or over. 

 

Depending on the 401(k) plan, you may only earn the employer-contributed portion over time, a process that’s called “vesting.” If you leave your employer before you’re fully vested, you’ll keep all your own contributions but may get only part of the company’s contributions. Research has shown that nearly half of plans immediately vested employees in employers’ matching contributions, while others can take five years or more to fully vest an employee.3

 

Traditional vs Roth 401(k)

There are two main kinds of 401(k) plan, which differ in when they provide you with a tax break. 

 

Traditional 401(k). As the name suggests, this is the original and most common type of 401(k) plan. With a traditional 401(k), you get a tax break when you contribute. Your contributions are taken from your paycheck before taxes are deducted, so they reduce your taxable income. Your money also grows tax-free while it’s in the 401(k) plan. However, you’ll pay income tax on the money you take out.   

 

Roth 401(k). You get a tax break when you withdraw the money, but not when you contribute – the opposite to a traditional 401(k). You pay taxes on the money that you invest in the plan, but you can withdraw money tax-free when you retire, as long as you meet certain conditions. 

 

A growing number of companies offer Roth 401(k) options in addition to traditional 401(k) plans. You can choose one or the other, or contribute to both, as long as the combined total doesn’t exceed the 401(k) contribution limit of $19,500 (or $26,000 if you’re 50 or more). You may pay less tax overall with a traditional 401(k) if you expect to be in a lower tax bracket after you retire – which may be the case if, like many people, you earn less after retirement. If not, you could pay less tax with a Roth 401(k).4 

 

Choosing 401(k) Investment Options

It’s important to think carefully when deciding which investment options to choose within your company’s 401(k) plan, because the decisions you make now may affect how comfortably you’ll be able to live when you retire.   

 

Typically, 401(k) plans offer a range of mutual funds and sometimes exchange-traded funds (ETFs). The funds invest in collections of stocks, bonds, or other financial assets. Some of the funds may aim for higher growth (which comes with higher risk), while others take a more conservative approach. Many plans include target-date funds, which alter the mix of assets to become more conservative as you approach retirement and have less time to recover if the value of your 401(k) falls. You may also be able to invest in individual stocks or bonds. If you find the choices bewildering, one option is to seek help from an impartial outside financial advisor who works on a fee-only basis, some experts say.5

 

Withdrawing Money from Your 401(k)

When withdrawing money from your 401(k), it can help to pay attention to some important guidelines. For example: 

 

To withdraw money invested in your 401(k) without paying a penalty, you typically have to be at least 59½ years old. With a Roth 401(k), there’s an additional requirement for penalty-free withdrawals: you must have had money in the plan for at least five years. Otherwise, the penalty is generally 10% of the withdrawal amount for either plan type. 

 

Eventually, you’re required to start withdrawing from your 401(k). With a either a traditional or Roth 401(k) plan, you generally must start withdrawing money at age 72 if you haven’t already done so (the SECURE Act increased the age from 70½, except for people who reached 70½ before the beginning of 2020). 

 

You’ll have to withdraw at least a minimum amount each year. Once you’re required to withdraw money from your 401(k), you must meet the Required Minimum Distribution (RMD) each year. Your RMD is calculated based on the balance in your retirement plan and your life expectancy. You’re also required to do this with money in a Roth 401(k), but experts say it’s possible to avoid the requirement by rolling the money into a Roth individual retirement arrangement (IRA), which isn’t subject to RMDs during the owner’s lifetime.6

 

What Happens if You Change Jobs?

If you leave your job, you have several options for your 401(k). You may be able to leave your account with the current plan provider. Alternatively, you can “roll over” the money into your new employer’s 401(k) plan, or into an IRA.

 

The Takeaway

If you’re an employee, your employer’s 401(k) plans may be a very convenient way to save for retirement. Like other kinds of retirement account, 401(k) plans provide tax breaks as an incentive for saving. They also offer the advantage of relatively high contribution limits, and many employers chip in additional matching funds.

Megan Doyle

Mike Faden has covered business and technology issues for more than 30 years as a writer, consultant and analyst for media brands, market-research firms, startups and established corporations.

 

All Credit Intel content is written by freelance authors and commissioned and paid for by American Express. 

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