The 5 Most Important 401(k) Terms You Should Know
If you are new to investing in your 401(k) plan, there are a few important concepts you should understand. Understanding these five terms will increase your chances of making decisions that can help you retire financially secure.
401(k) Matching Rate
The 401(k) matching rate is the rate at which your employer will match your own contributions to the retirement plan. An employer that matches dollar-for-dollar, or 100%, would contribute $1 to your 401(k) for every $1 you saved in it, instantly doubling the money you have to invest. If your employer matched 50 cents on the dollar, or 50%, you would see an extra 50 cents deposited into your 401(k) for every $1 you saved through the account.
401(k) Matching Limitation
Companies know that 401(k) matching is a great deal. They do it to help their employees invest for retirement and to help attract talented workers. But virtually all companies place a limit on the percentage of your salary you can contribute to a 401(k) plan and receive matching funds.
A common matching fund limitation for 401(k) accounts is 6% of salary. Less generous employers may set a limitation of 3% of salary.
To illustrate: If you earn $50,000 a year and your company matches 401(k) contributions on a 100% basis up to 6% of salary, you will receive $1 for every $1 you save for the first $3,000 you put into your 401(k) account ($50,000 x 0.06 = $3,000 match limitation). Additional money contributed above that matching threshold and below the 401(k) contribution limit will not receive any matching from your employer, but you still may want to set aside more than that percentage of your income for retirement.
401(k) Contribution Limit
Because the contributions are pre-tax, Congress puts limits on the amount of combined income employees and employers can contribute to a 401(k) account. These limits are adjusted annually to account for inflation.
In 2020, workers can invest $19,500 of their annual pay. If you're 50 or older, you can invest an additional catch-up contribution of $6,500.
The maximum combined amount that can be contributed in 2020 by an employee and their employer is $57,000 or, if the employee is 50 or older, $63,500.
401(k) Tax Deduction
When you contribute money to your 401(k), the IRS treats the contribution as a tax deduction, so you don't owe payroll or income taxes on it. That is, if you invest $5,000 through your 401(k) account, and you had $50,000 in income, you are going to see a $5,000 tax deduction, lowering your adjusted gross income to $45,000. It isn't always that simple, but for the most part, this is how it works if you are an average employee.
Your 401(k) contributions have a bigger advantage as you make your way into higher income tax brackets. If you and your spouse are in the combined 25% tax bracket and you file jointly, a $5,000 401(k) contribution will lower your federal tax bill by $1,250 ($5,000 contribution x 0.25 = $1,250).
401(k) Hardship Distribution
In some cases, it's possible to withdraw money from your 401(k) plan without being required to pay it back. It's known as a 401(k) hardship distribution.
Not all employers permit it, so if you feel like you need to make a hardship distribution, you should check with your plan administrator or HR representative to see whether it's possible. If it is permitted, you also must be using the funds to pay for "an immediate and heavy need," according to the IRS, and you may not withdraw more than is required to pay for that need.
The IRS considers the following situations to automatically qualify as "an immediate and heavy need":
- Medical care expenses for the employee, the employee’s spouse, dependents, or beneficiary
- Costs directly related to the purchase of an employee’s principal residence, but not including mortgage payments
- Tuition, related educational fees, and room and board expenses for the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents, or beneficiary
- Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence
- Funeral expenses for the employee, the employee’s spouse, children, dependents, or beneficiary
- Certain expenses to repair damage to the employee’s principal residence
You must also state in writing that you are unable to obtain the necessary funds from another source.
Hardship withdrawals are subject to income taxes and perhaps also a 10% penalty on early distributions.