By Stacey Ritzen, WCI Contributor
Any financial advisor worth their salt will tell you that, hands down, the easiest and most straightforward way of saving for your retirement is through a 401(k) plan. Many employers offer 401(k) plans as part of their corporate benefits package, so in many cases, you don’t even have to do the legwork on your own.
Whether you can enroll in a 401(k) plan through your employer or you need to open a 401(k) on your own, it can be a daunting process for those new to the exciting world of retirement savings. Where does your money go after you contribute? How do you know that it’s being invested and managed properly? But these concerns shouldn’t prevent you from taking advantage of your company’s 401(k) plan as soon as you’re financially able (starting the process while in residency is a great idea).
After all, getting a head start on investing in your 401(k) early in your career can be crucial for a robust retirement outlook—which is why we’re here to help walk you through the process.
What Is a 401(k) Plan?
A 401(k) refers to the type of retirement savings and investment plans that employers offer, aptly named for the subsection of the tax code that outlines these plans (subsection 401(k) of the Internal Revenue Code). The most significant difference between investing your money in a 401(k) as opposed to a savings account or taxable brokerage account is that the 401(k) enjoys significant tax breaks, often including a huge deduction up front.
How Do 401(k) Plans Work?
When opting into a company’s 401(k) plan, tax-free contributions are automatically deducted from the employee’s paycheck. These contributions are then invested in a portfolio with mutual funds being the most common type of investment offered. Employees can likewise choose from various risk-based options, ranging from conservative to moderate or even aggressive.
However, just because you avoid paying taxes on the money you contribute to your 401(k) doesn’t mean that the IRS doesn’t eventually get its cut. Once an individual reaches retirement age and begins to make withdrawals from their 401(k), those funds, which were allowed to grow tax-free, are then taxed as regular income based on federal income tax brackets in the fiscal calendar year the withdrawals are made. However, if there are no other sources of taxable income, the 401(k) withdrawals fill the tax brackets as you go, providing a substantial arbitrage between the tax rate you saved at contribution and your effective tax rate at withdrawal.
Contributing to a 401(k)
Though 401(k) plans are offered by employers, the administrative details are set up by the company’s 401(k) plan administrator, which is typically an outside financial firm like Fidelity or Schwab. These administrators can help employees enroll in and manage their plans by determining how much they decide to withhold and how those funds are allocated.
What Is the Max Contribution Limit for 2022?
The catch when it comes to 401(k) plans is that there’s a limit to which Uncle Sam will allow you to circumvent taxes. And regardless of income level or tax bracket, the maximum annual 401(k) contribution limit in 2022 amounts to $20,500 for those 49 and younger. If you're 50 or older, you can put in a catch-up contribution of $6,500, meaning they could contribute a total of $27,000. In 2023, those limits were raised to $22,500 with a catch-up contribution of $7,500, meaning those who are 50 or older can contribute a total of $30,000.
Are you saving enough for retirement? Get a personalized answer with this FREE retirement calculator powered by NewRetirement.
Employer Match
In some instances, companies will even offer to match up to a certain percentage of employee contributions. For example, a typical employer match might amount to 3% of the employee’s salary or 50% of the first 6% contributed.
If you’re fortunate enough to be enrolled in employer-match 401(k) plans, it’s recommended that you contribute the full amount—or as much as you can swing financially. After all, that’s essentially free money going toward your retirement. For example, if you earn $200,000 in a year and your employer matches 3%, you'd be getting an additional $6,000 for free. That's a nice benefit.
The employer match does not count against the annual employee deferral limit. No matter what, you can still contribute a maximum of $20,500 in 2022, and then your employer can put more into the account. The total of employee and employer contributions for 2022 can be as high as $61,000 for those under 50, but few employer 401(k)s are set up to allow for that large of a contribution because it would result in discrimination against the non-highly compensated employees.
Other Tax Benefits of a 401(k)
The tax protected growth isn't the only tax benefit of contributing to a 401(k) plan. It will also help reduce your adjusted gross income, which is used to calculate taxable income.
For example, say you earn a salary of $225,000 and contribute $20,500 to your 401(k). That would mean your taxable income would be lowered to $204,500 because of the 401(k) contribution. Doing that would put you into the next lower marginal tax bracket (which is for single people who earn between $164,926-$209,425) instead of the 35% tax bracket (for those who make between $209,426-$523,600). But most of the tax savings on that $20,5000 contribution would happen at 35%, saving you about $7,000 on this year's federal tax bill!
How Much Should You Contribute to a 401(k)?
Depending on how much you can afford, most financial experts recommend contributing 10%-15% of your annual income toward your 401(k). Some may even recommend up to 20%. Of course, this is provided that you still fall under the maximum annual contribution limit. If you can afford it—and if you're making an attending salary, you certainly could—contribute the maximum every year. After all, it's one of the best ways to save for retirement. In fact, many doctors find that to get to the 20% of gross income for retirement rule of thumb that The White Coat Investor recommends, they have to max out their 401(k) and do a Backdoor Roth IRA and invest money into a taxable account.
Again, if your employer offers to match a percentage of your 401(k) contributions, you’d be hard-pressed to find a financial adviser who would tell you to contribute anything below the employer match, provided you can afford it.
How and When to Withdraw from Your 401(k) in Retirement
In general, penalty-free withdrawals from retirement accounts can only occur after age 59 1/2, although if you're working for an employer at age 55, you can tap that 401(k) after separation. Aside from a few exceptions (including early retirement via the SEPP rule), the IRS charges a 10% penalty for early withdrawals before turning 59½ on top of the regular income tax rate.
Though most people opt to withdraw from their retirement savings in regular monthly or annual distributions, you can also collect the money in a lump sum.
From 55 through the age of 72, you can withdraw as much or as little from your 401(k) as you like. However, once you turn 72, you must begin taking required minimum distributions (RMDs) from your 401(k), calculated using an IRS formula based on the account holder’s age. There is one exception: if you’re still employed at 72 by the same company, some plans allow you to postpone RMDs until the date you actually retire.
Hardship Withdrawals
Life comes at you fast, and in the event that you’re hit with a severe financial crisis that you otherwise couldn't afford, you may be permitted to begin taking early withdrawals from your 401(k) without incurring a penalty.
These withdrawals are known as hardship distributions. They are subject to various criteria depending on your plan while considering other assets such as savings or investment accounts. Examples of legitimate hardships include medical expenses incurred from illness or injury, burial or funeral expenses, educational tuition and fees up to 12 months, home-buying expenses for a down payment or closing costs, or home repairs due to a natural disaster.
Can I Borrow from My 401(k)?
If you don’t meet the criteria for a hardship distribution, another option is borrowing from your 401(k) to avoid an early withdrawal penalty. However, the terms of these loans are subject to an individual’s specific employer and plan, and eventually, they must be repaid in full, plus interest.
Although borrowing from your 401(k) is subject to your plan's rules, the IRS also dictates how much you’re allowed to borrow. For example, the limit for 401(k) loans cannot exceed 50% of your vested balance, up to $50,000 in a calendar year—even if you take out multiple loans.
These loans also must be paid back within five years or whenever you leave your current job, whichever happens first. And if you fail to repay the balance, you’ll be subject to both the 10% penalty and applicable taxes. For this reason, most financial advisors don’t recommend borrowing from your 401(k) if other options exist.
The Rule of 55
There is one final provision for early 401(k) withdrawals for those who lose their job or retire between 55-59½. It's called the Rule of 55, and it allows employees to begin withdrawing funds without incurring the 10% penalty starting the year they turn 55.
The catch is that the Rule of 55 only applies to your 401(k) with your current employer. Therefore, any 401(k) accounts you may hold with former employer plans or other individual retirement accounts still require you to reach the age of 59½ before taking penalty-free distributions. It only applies to the 401(k) for the employer you had after you are already 55.
What Happens to My 401(k) If I Change Jobs?
If you leave your employer or are laid off, there are several options of what you can do with your 401(k) savings—depending on the balance.
If you are switching jobs and your new employer offers a 401(k) plan, the easiest solution is to simply roll your 401(k) balance directly into your new plan to avoid incurring taxes or penalties. Another option is to roll your 401(k) into an IRA, but this is not recommended for high earners who wish to do a Backdoor Roth IRA because it will cause the Roth conversion step to be pro-rated.
However, you can also leave your money in your former employer’s plan, provided your account meets the minimum balance requirement of $5,000. But even then, it’s a wise idea to stay on top of that account in case the company goes out of business or something else catastrophic happens. Your money will remain protected, but finding a plan administrator to assist with your 401(k) could pose a potential nightmare.
Cashing out is also an option, though it's not recommended. You will incur taxes and a penalty, and you'll be missing out on an opportunity to save for your retirement, since that money would only continue to grow when invested. If you have less than $5,000 in your 401(k) account, your employer can also force you to cash out, so it’s crucial to explore your options quickly.
How to Open a 401(k) Without an Employer
The only way to open your own 401(k) without an employer is for those who are self-employed. The participant is both the employer and the employee in this situation, and an individual 401(k) (sometimes called a solo 401(k)) comes with a few benefits. Not only are you allowed to contribute more money to a 401(k) than other types of retirement plans, but you can also match your own contributions from your company’s profits in the role of the employer. It's much easier to get a full $61,000 into the plan when you have an individual 401(k).
For self-employed physicians, a solo 401(k) is a great option. Note that you are not limited to one 401(k) per year, but if you have access to more than one, it is critical to understand the rules governing how much you can contribute to multiple 401(k)s.
If you’re not self-employed but cannot participate in your employer’s 401(k) plan for one reason or another—or even if you want to contribute to multiple accounts—there are other options available.
Alternatives to 401(k) Plans
Individual retirement accounts, or IRAs, is a great way of saving for your retirement without a 401(k). The primary difference is that instead of your company’s plan administrator, IRA funds are managed by custodians that you appoint, such as commercial banks, mutual fund companies, and retail brokerage firms. The withdrawal rules are similar to 401(k) plans but without the age 55 rule.
However, there is a smaller cap on annual contributions with IRAs than with 401(k) plans. In 2022, $6,000 is the maximum per year that earners under 50 can contribute to an IRA ($7,000 for those 50 and older). Likewise, there are income limits to tax deductibility for those already enrolled in an employer 401(k) plan and who wish to contribute to an IRA.
Defined Benefit Plans, Backdoor Roth IRAs, Health Savings Accounts, and taxable investing accounts are all places you can invest additional money.
We all know we should be saving for retirement, and by now, you should know that, if it's possible, you should be maxing out your 401(k) contributions every year. Contributing to a 401(k) isn't the only step you should take to prepare for your post-retirement life, but it's certainly an important one.
If you need extra help with planning for retirement or have
questions about the best way to save your money in tax-protected accounts, hire a WCI-vetted professional to help you figure it out.
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Hello
I was wondering I have 15 years until retirement.
I plan to invest in one etf/stock and not do any selling or buying of more assets.
I was curious if I left it in a retirement vs in a brokerage account and wanted to withdraw the money at age 59.5 as a lump sum if it would be better to go with a brokerage account since the capitals gain would be less than the 401k pretax dollars. Lets presume it would funded with aftertax dollars.
x amount in 401k pretax at 15 years at 36% tax bracket
x amount in brokerage at 15 years at capital tax rate?
Thank you
Weird scenario, but you’d be better off in the retirement account like usual, even in that scenario.
Think of it this way: Invest $30K into a pre-tax retirement account or invest $20K into a brokerage account. Then the retirement account grows tax-protected while the brokerage account gets taxed every year. THEN apply the tax treatment you’re talking about. Now it doesn’t look so good to just pay the capital gains rates, right?
Hello
I am sorry to ask this here but this is an unrelated question.
If I for example got CME money from my job and then used it to buy something that was later refunded when I left the job (for exampled cancelled the product) do I have to give that back to the employer or can I retain that income for myself. If I do I would need to pay taxes on it presumably.
Thank you
I don’t think anyone is looking at it closely enough to really answer your question of whether you have to or not. In practice, I don’t think anyone would give it back or pay taxes on it. I’d keep it and wouldn’t pay taxes on it.
Where can I get more information about setting up a 401k for my dental office? We have 26 employees and currently have an Simple IRA but would like to offer more. Can shed some light on this and point me in the right direction?
It’s not a do it yourself project. Hire one of these guys:
https://www.whitecoatinvestor.com/retirementaccounts/
If you want to read more, try this post:
https://www.whitecoatinvestor.com/starting-a-401kprofit-sharing-plan-for-a-small-practice-friday-qa-series/
My question relates to solo 401k, 403b, and 457b accounts and minimizing taxation. Forgive me if this seems in the weeds.
I work for a non-profit hospital, and make an adequate w2 salary. My employer offers a 403b and a 457b retirement account. I make maximum employee contributions to both of those accounts with $22,500 each. Additionally, my employer makes contributions to a 401a performance/match account of approximately $11,250 each year. By my math, 22,500 + 22,500 + 11,250 = $56,250.
I also am an independent contractor at a local unrelated hospital, and am paid via 1099 income. If I wanted to make contributions to a solo 401k, would I be limited by my prior contributions? If so by how much? Does the 457b play a role in my contribution limit? I see three different scenarios, see below.
1. Because this is an unrelated hospital, and I have made zero 401k contributions, could I make maximum employee contributions and employer contributions of 22,500 and 43,500 for a total of 66,000. This doesn’t seem right. I believe a 403b and 401k are considered similar accounts by the IRS and they should be summed together. Which brings me to scenario 2
2. Current 403b (employee) and 401a (employer) contributions = 22,500 + 11,250 = 33,750. Which means I could contribute 66,000 – 33,750 = $32,250 as an employer contribution (max 20% of income) through my solo 401k. Unless, the 457b also should be considered in this equation. Which would bring me to the third option.
3. Total contributions for the year = (22,500 403b employee contribution) + (22,500 457b employee contribution) + (11,250 401a employer contribution) = 56,250. In this scenario I can only make a contribution of 9,750 to my solo 401k as an employer contribution (max 20% of income)
Which of these 3 scenarios is technically correct? Appreciate any thoughts. Thank you.
Yes, not only with regards to the employee contribution you already used in the 403b but the 403b and the Solo 401(k) would share the same $66K total contribution. More details here:
https://www.whitecoatinvestor.com/multiple-401k-rules/
No, the 457(b0 limit is totally separate.
1 is incorrect
2 is incorrect
3 is also incorrect
You can put up to $66K – $22,500 = $43,500 into the solo 401(k) as an employer contribution (assuming your net profit was at least $43,500/20% = $217,500 or if your solo 401k allows it (usually a custom designed one), you can put it in as an after-tax contribution if you make at least $43,500 in net profit. Then you convert that after-tax contribution to Roth 401(k), again if your plan allows it.
Read the link above. It goes over all this. Note that if your employer’s retirement plan was a 401(k) instead of a 403(b) you could put the full $66K into the solo 401(k). That one is a weird rule.
Can I contribute to a solo401k plan in the year following the plan year?
For example for 2023 I make x amount of money and I contribute y amount but I find that I could have put more money into 2023 401k but I did not do it until I realized that in 2024 before filing taxes? Is it is still too late?
Thank you
You as the employer? Yes, you’ve always been able to do that. There was a change about this in the Secure Act 2.0 though as I recall. Now you can do employee contributions late too.
https://www.whitecoatinvestor.com/secure-act-2-0/
Here it is:
ΔSection 317: Solo 401(k)s Started After the Calendar Year Can Now Get Employee Contributions
I used to recommend that you use a SEP IRA if you don’t get your solo 401(k) established by the end of the year. Now, you can just establish your 401(k) before your tax return date and still make employee contributions to it. No reason now to use the SEP IRA and mess up your Backdoor Roth IRA pro-rata calculation. Starts in 2023 (for 2023 contributions, not 2022 contributions.)
My company has a 401k match and my annual salary is 175,000. When going through contractual negotiations, it was agreed upon that my match would be “401(k) with up to 5% match of annual salary” as stated in the contract.
I contributed the full $22,500 for 2023 by contributing 100% of my income the first 3 months and realized that they were actually only matching 5% of my contributions per pay period (approximately $300 per 2 week pay period). So according to what they have told me, I have essentially been missing out on matching due to maxing out contributions early (essentially missing the 5% match for 9 months)
These are my questions:
1) With what was explicitly written in my contract, shouldn’t they match 5% of $175,000 being $8,750 immediately once I have contributed at least $8,750?
2) Am I missing something here? I feel as though this was explicitly written in the contract and may be grounds for breach of contract.
Thank you for everything WCI had done as it has changed my financial life.
1. Good luck taking them to court. This is not terribly uncommon. It’s important to ask if your 401(k) match works with an end of year “true-up” option or not before maxing it all out early in the year. Live and learn. Contribute gradually this year. My DBP is making me make gradual contributions this year against my will and I’m on the retirement plan committee!
2. Good luck taking them to court. “up to 5%” is what they gave you. 1% is up to 5%.