FAQs on 401(k)s
The skinny on Roth versus traditional contributions, early withdrawals, loans, and more.
Note: A version of this article originally appeared in January 2014.
What are the main benefits of investing in a 401(k) versus investing on my own?
For starters, your employer will likely match at least a portion of your contributions--that is, contribute company money on your behalf, as long as you are contributing some of your own money to the account. Try getting your employer to match you on contributions to your bank account!
There are also tax-related benefits. If you contribute to a traditional 401(k), you'll make pretax contributions, and you won't have to pay any taxes on the account as the money grows. You'll pay taxes at your ordinary income-tax rate when you begin withdrawing the money, and you'll also be required to begin withdrawing the money on a set schedule (required minimum distributions) once you're age 72. If you contribute to a Roth 401(k), you'll contribute dollars that have already been taxed, but you'll enjoy tax-free compounding and tax-free withdrawals on your money in retirement.
By contrast, if you contribute to a taxable account on your own, you'll only be able to contribute aftertax dollars, you'll owe capital gains and income tax on any distributions during your holding period, and you'll pay capital gains on any price appreciation when you sell.
Additional benefits of investing in a 401(k) plan include the ability to automate your contributions as well as the fact that you may be able to gain access to ultra-cheap institutional fund shares that aren't available to you as an individual investor.
How much can I contribute to a 401(k)? Are there income limits on contributions?
Savers under age 50 can contribute $19,500 to a 401(k) in 2019; those over 50 may contribute $26,000 this year. (You can start making those extra catch-up contributions on Jan. 1 of the year you turn 50; you don't have to wait until your birthday.) The contribution limits are the same regardless of whether you contribute to a Roth or traditional 401(k). In contrast with IRAs, there are no income limits on contributions to 401(k)s.
If I trade securities in my 401(k) plan prior to retirement, is my 401(k) provider or the IRS keeping track of the capital gains I'm realizing, and will I get socked with a big capital gains bill in retirement?
No. If you're contributing to a traditional 401(k), all of your withdrawals will be taxed at your ordinary income tax rate, regardless of whether the withdrawal consists of contributed money or investment appreciation. So even though we wouldn't advise it, you can buy and sell securities all day long and you won't have a direct impact on your ultimate tax bill.
My company has a Roth and traditional 401(k) option. How can I figure out which account type is right for me?
Your analysis should hinge on your assessment of whether your tax rate today is likely to be higher or lower than it will be in the future. If you think it will go higher, either because you expect taxes at large to go up or because you think your personal income situation will get much better, you're better off making Roth contributions. If you haven't saved much and retirement is close at hand, you're probably better off making traditional 401(k) contributions, because your tax rate in retirement may be lower than it is today. And what if you have no idea? In that case, it may make sense to split your contributions across both types of account or, if you already have substantial assets in a traditional 401(k) or IRA, to direct new contributions to your Roth 401(k) to help diversify the tax treatment of your 401(k) dollars. If you think your tax bracket in the future will stay the same as it is today, the tax effects will be the same whether you invest in a Roth or traditional 401(k).
At what age can I begin withdrawing my money?
The standard age for penalty-free withdrawals from both IRAs and 401(k)s is 59 1/2. But early retirees have a bit more latitude to tap their 401(k)s than they do IRAs. If they've left their employers at age 55 or later and keep their money in the old 401(k), they can take penalty-free withdrawals from the plan, though they'll still owe tax on those distributions. They do not have the same latitude if they've rolled the money over to an IRA; there they'll owe the 10% penalty on withdrawals prior to age 59 1/2. So-called 72(t) distributions also allow 401(k) and IRA investors under age 59 1/2 to circumvent the 10% early-distribution penalty, but they'll have to take out their money as a series of "substantially equal distributions" for a period of five years or until they turn age 59 1/2, whichever is longer.
What if I need to get my money out before I'm retired? Is that allowed?
Generally speaking, you can't take a distribution from a 401(k) plan while you're still working and under age 59 1/2 unless your situation counts as a hardship withdrawal--for example, if you need to pay medical bills or for higher education costs--and your plan allows for such distributions. You'll pay ordinary income tax and a 10% penalty on the money, but the 10% penalty is waived in very specific situations--for example, if you're disabled or you have medical bills that exceed 7.5% of your adjusted gross income. The CARES Act, passed in early 2020, allows investors who have been affected by the coronavirus to take withdrawals from their accounts without penalty, though they will owe taxes.
If you've left your employer, you also have latitude to pull your money out of your former employer's 401(k) at that time--you won't have to demonstrate hardship circumstances. However, you will have to pay taxes and a 10% penalty on those withdrawals unless you roll that money into an IRA or your new employer's 401(k); you'll also starve your nest egg of long-term appreciation potential.
Some of my colleagues have borrowed money from their 401(k)s. What are the drawbacks, and how does a 401(k) loan stack up to other sources of emergency funding?
Tapping any sort of retirement account should be way down in the queue if you need funds for emergency expenses; exhaust emergency cash and any taxable investments first.
That said, a 401(k) loan can be more attractive than some other sources of emergency funding, in part because you pay interest back to yourself rather than a third party. That stands in contrast to tapping a home equity line of credit or using credit cards to cover your short-term cash needs. You can generally borrow up to 50% of your vested account balance or $50,000 from your plan, whichever is less, and the loan must be paid back in five years or fewer, unless the loan was for a primary residence. (Here again, the CARES Act has temporarily loosened up the strictures around 401(k) borrowing for people affected by COVID-19.)
But borrowing from a 401(k) doesn't come without risks. The big one is that if you lose or otherwise leave your job, you'll have to pay the money back, or the amount of the remaining balance will count as an early distribution and be subject to ordinary income taxes and a 10% penalty.