What Is a 401(k)?

by Team eLocal
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As you browse your employer's benefits package, you'll often see a 401(k) plan as a retirement fund option.

What is a 401(k), and how can it help you prepare for retirement? Your questions — answered.

What Is a 401(k) Plan and What Is It For?

A 401(k) plan is a common type of retirement account that's sponsored by your employer. You can contribute to your 401(k) plan through payroll deductions that come out pre-tax, which lowers your taxable income as you save for retirement.

You typically designate a percentage of your paycheck, and your employer can match part of your contributions or make a set contribution. Your 401(k) contributions are capped each year. The yearly limit for 2022 is $20,500, with adjustments made regularly for inflation. If you're 50 or older, you can contribute an additional $6,500 as a catch-up contribution.

The purpose of a 401(k) plan is to save for retirement. While you can withdraw money early, you'll face a penalty. Your contributions are invested to potentially earn interest to help grow your retirement savings. Starting a 401(k) early in your career helps it grow faster due to compound interest.

How Do Taxes Work on a 401(k)?

You contribute to your 401(k) plan before taxes are taken out, which means you won't pay taxes on that money. You pay taxes on the money when you withdraw it from the retirement account.

When Can You Withdraw Money From a 401(k)?

A “distribution” is the term for withdrawing money from the 401(k). The minimum age to start withdrawing money is 59.5, unless you have a qualifying financial hardship or other special circumstances. You can withdraw money early, but you'll pay taxes, plus a 10% penalty. A 401(k) loan is another option, allowing you to avoid penalties by borrowing money from your 401(k) and paying it back within a certain time.

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