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.
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.
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.
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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