Retirement Planning Basics: the 401(k)
Austin has long been an oasis for entrepreneurs, with fertile soil to plant ideas and an ideal climate for innovation. In recent years more and more companies are recognizing this and are migrating to Central Texas to join our entrepreneurial ecosystem. As Austin becomes home to more and more emerging companies, top talent is also moving to Hill Country for their employers.
While many of these talented people are seasoned professionals, some are more green and new to the world of robust employee benefits. They come equipped with a lot of knowledge about their field and less prepared to navigate the nuances of things like healthcare and retirement plans. Keeping these young Austinites in mind, we are initiating a series addressing retirement plans for the novices and newbies new to the 512.
To kick us off, we’ll give you the 411 on 401(k)s.
What is a 401(k)?
A 401(k) is an employer-sponsored retirement account with a dedicated contribution plan that gives employees the opportunity to invest in their retirement with certain tax advantages. It’s named after the 401(k) section of the tax code that defines and establishes this type of plan.
Before 401(k)s were created, most employees relied on a pension for their retirement planning—an amount that their employer committed to distributing to them during their retirement. Now, pensions are far less common, and most people utilize 401(k)s and other individual savings options.
Employees can dedicate a portion of their earnings to the plan, which invests their money in a variety of vehicles such as stocks, bonds, and mutual funds. The options depend on the employer’s chosen plan, and may include offerings such as target-date funds, index funds, and more.
Traditional vs. Roth
There are two main types of 401(k) plans: traditional and Roth. The key difference lies in how each is taxed.
With a traditional 401(k), contributions are made pre-tax, reducing taxable income for the year. Taxes are paid when funds are withdrawn in retirement.
With a Roth 401(k), contributions are made with after-tax income, but withdrawals—including earnings—are tax-free in retirement.
Some employers offer both types, and employees can split contributions between the two if desired. A financial advisor can help determine the ideal balance based on tax bracket and retirement timing.
Employer Matching
One of the biggest perks of a 401(k) is employer matching. Employers often match a percentage of an employee’s contributions—commonly dollar-for-dollar or 50 cents per dollar—up to a certain limit. It’s often referred to as “free money,” and for good reason.
Maximizing contributions to receive the full employer match is widely recommended, as this helps your retirement savings grow significantly faster.
IRS-Imposed Limits
Each year, the IRS adjusts 401(k) contribution limits based on inflation. For 2021, the cap for employee contributions was $19,500; in 2022, it rose to $20,500. Workers over 50 can make an additional “catch-up” contribution of $6,500.
With employer matching, the total allowable contributions can rise to $58,000 in 2021 and $61,000 in 2022 (or $64,500 and $67,500 for those 50 and over).
If You Move On Before Retirement
Changing jobs? That’s where a 401(k) rollover comes in. Funds can be transferred to:
A new employer’s 401(k) plan
An Individual Retirement Account (IRA)
Or in some cases, left with the former employer
Each option has pros and cons. An IRA offers greater investment flexibility but requires more hands-on management. Keeping funds with the old employer may be simple, but only makes sense if the plan is well-managed. A professional advisor can help avoid tax pitfalls and optimize returns during a rollover.
401(k) Withdrawals
Withdrawals before age 59½ usually incur a 10% early withdrawal penalty.
Required Minimum Distributions (RMDs) begin at age 72 unless you're still working.
A Roth 401(k) can offer tax-free withdrawals if held for at least five years.
Because of the penalties and restrictions, it’s wise to keep emergency savings outside your 401(k) to avoid having to dip into your retirement funds early.
Final Thoughts
If you expect to be in a lower tax bracket in retirement, a traditional 401(k) might be more advantageous. If you expect to be in a higher bracket—or simply want tax-free income later—a Roth 401(k) can be a strategic choice. The best option depends on your goals, income, and timeline.
There’s a lot to consider in terms of your career and how it can play a role in your financial planning. Reach out to us at info@nestfinancial.net to maximize your retirement options and create a financial plan that gives you freedom and confidence—both now and in your golden years.
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DISCLAIMER: The information and opinions shared in this article are for educational purposes only and are not financial planning or investment advice. For personalized guidance, contact us at info@nestfinancial.net.