401(k) Retirement Planning Essentials

401(k) retirement planning is essential for most Americans who want to retire with a comfortable and sustainable lifestyle.

By Will Grant, CFP® CPWA® of 360 Financial

As a CERTIFIED FINANCIAL PLANNER™ and Certified Private Wealth Advisor®, Will helps clients create their ideal life through values-based financial planning. His process is designed to pursue each client’s objective, whether it’s preparing for retirement, ensuring smooth business succession, funding for education, implementing wealth transfer strategies, or navigating other impactful financial events.

Retirement Planning and Your 401(k) Plan

Retirement planning is an essential step to ensure financial security later in life. The 401(k) plan is one of the most popular tools used by Americans for retirement. 

By setting aside a portion of their income, employees can build a nest egg and start building wealth and preparing for retirement. Additionally, many employers offer matching contributions, further boosting the potential savings. Understanding the ins and outs of a 401(k) is vital for maximizing its benefits.

Let’s go over the benefits of using your 401(k) as part of your retirement plan. 

Table of Contents

1. What is a 401(k) Plan?
2. How does a 401(k) retirement plan work?
3. Traditional 401(k)
4. Roth 401(k)
5. How to Contribute to Your 401(k) Plan for Retirement
6. Pros of a 401(k) for Retirement Planning
7. Cons of a 401(k) for Retirement Planning
8. Contribution Limits of a 401(k) Plan
9. 401(k) vs IRA for Retirement Planning 
10. 401(k) Updates for 2023
11. Required Minimum Distributions i.e. What You Have to Withdraw at Retirement
12. What to Do with Your 401(k) When You Switch Employers
13. Common Questions about Retirement Planning and 401(k) Plans
14. Work with a Financial Advisor Online or In Person

What is a 401(k) Plan?

A 401(k) is a retirement savings plan sponsored by employers for their employees. It allows you to save a portion of your paycheck before taxes are taken out. These funds are then invested in a variety of options, including stocks, bonds, and mutual funds. 

Over time, these investments can grow tax-deferred until withdrawals are made in retirement. The name “401(k)” comes from the section of the U.S. tax code that outlines its provisions.

How does a 401(k) retirement plan work?

As an employee, you decide how much of your paycheck you want to contribute to your 401(k) plan. This money is then deducted from your wages or salary before taxes, reducing your taxable income. 

Employers can also contribute to the plan, often through matching your contributions up to a certain percentage. Investments in the 401(k) grow tax-free until they are withdrawn. Once you reaches retirement age, you can start withdrawing from your 401(k), at which point the distributions (i.e. withdrawals) are typically taxed.

Traditional 401(k)

In a traditional 401(k), contributions are made pre-tax, which means taxes are deferred until funds are withdrawn. This allows employees to reduce their current taxable income, potentially placing them in a lower tax bracket. 

The investments grow tax-deferred, compounding over time. Withdrawals made in retirement are taxed as ordinary income.* 

Penalties usually apply if funds are withdrawn before age 59½, with certain exceptions.

*Ordinary income refers to the regular income an individual receives that is subject to standard tax rates, as opposed to preferential tax rates. It encompasses income generated from typical sources like wages, salaries, commissions, and rental income, among others. 

Roth 401(k)

The Roth 401(k) option allows participants to contribute post-tax dollars. Unlike the traditional 401(k), withdrawals in retirement are generally tax-free, assuming certain conditions are met. This can be a beneficial choice for those who anticipate being in a higher tax bracket during retirement. 

Contributions to a Roth 401(k) don’t reduce your taxable income for the year. However, the trade-off is the potential for tax-free withdrawals later on.

Determining which 401(k) plan makes sense is an important decision that will depend on your specific situation. Click here to schedule a time consult with one of our 360 Financial Wealth Managers. 

Schedule a 15-minute Call

How to Contribute to Your 401(k) Plan for Retirement

To start contributing, employees typically select a percentage or fixed amount of their paycheck to allocate towards their 401(k). It’s crucial to review and potentially increase contributions annually to account for salary increases or changing retirement goals. 

Taking advantage of employer match programs is essential, as it’s basically “free money” for retirement. Regularly reviewing the investment options within the plan can help ensure alignment with your financial goals.

EXAMPLE:

It’s important to continuously review your 401(k) contributions and increase when appropriate. The difference can be significant. For instance, if a 25-year-old with a $100,000 income contributes 3% of their salary to their 401(k) annually and receives a 3% employer match, they would be saving $6,000 per year.

Assuming an average annual return of 7% on their investments, by the time they reach 65, their 401(k) balance would be approximately $1.2 million.

However, if they were to increase their contribution rate to 10%, the annual savings would amount to $13,000 including the 3% employer match, resulting in a substantially larger retirement fund. With the higher contribution rate of 10%, the 25-year-old would have amassed a retirement fund of around $2.6 million by age 65, assuming the same 7% average annual return.

This substantial difference showcases the power of higher contributions, allowing the individual to retire with financial security and the ability to enjoy a comfortable lifestyle.

Pros of a 401(k) for Retirement Planning

401(k) plans come with the significant benefit of tax-deferred growth.

Tax-deferred growth refers to the increase in value of an investment in which the taxes on the investment’s earnings are not paid until a later date, typically upon withdrawal. In other words, while the investment grows and earns interest, dividends, or capital gains, no taxes are due on those earnings until they are withdrawn or distributed. 

The primary advantage of tax-deferred growth is the compounding effect. Because taxes aren’t taken out annually, the entire amount of earnings is reinvested and can earn even more. Over time, this can lead to significantly more growth compared to an account that’s taxed annually.

Many employers provide matching contributions, amplifying the amount saved. The array of investment options within a 401(k) can cater to different risk tolerances and financial objectives. Employees have the option to borrow against their 401(k), though it’s generally not recommended. High contribution limits make 401(k)s ideal for those looking to save sizable amounts.

Cons of a 401(k) for Retirement Planning

There are some cons to 401(k)s, so it’s important to review some of the downsides. Early withdrawals from a 401(k) can incur hefty penalties and taxes. Investment options can be limited compared to other retirement accounts, potentially hindering diversification. Some plans come with high fees that can eat into overall returns. 

Unlike Roth IRAs, traditional 401(k) distributions are taxable upon withdrawal. It might be complex for individuals to understand all plan details, potentially leading to sub-optimal choices. In fact, if you want to feel more confident in your future retirement, I recommend that you seek the advice of an experienced fiduciary Wealth Manager. 

Contribution Limits of a 401(k) Plan

Each year, the IRS sets limits on how much individuals can contribute to their 401(k) plans. For 2023, the contribution limit might be adjusted based on inflation and other economic factors. 

Catch-up contributions are allowed for those aged 50 and above, letting them save more as they near retirement. These limits do not include employer matches, which can further boost retirement savings. It’s essential to be aware of these limits to maximize contributions without incurring penalties.

The 401(k) contribution limit for 2023 is $22,500 for employee contributions. If you’re age 50 or older, you’re eligible for an additional $7,500 in catch-up contributions, raising your employee contribution limit to $30,000.

401(k) vs IRA for Retirement Planning 

Both 401(k)s and IRAs are powerful tools for retirement savings. While 401(k)s are employer-sponsored, IRAs are individual retirement accounts anyone can open. IRAs often offer a broader range of investment choices compared to 401(k)s. 

However, 401(k)s typically have higher contribution limits, especially when including employer matches. The choice between the two often depends on individual circumstances, financial goals, and the availability of employer-sponsored plans.

401(k) Updates for 2023

As financial landscapes evolve, so do regulations and provisions for retirement accounts. In 2023, there may be updates regarding contribution limits, withdrawal rules, or other plan features. 

It’s vital to stay informed about these changes to optimize retirement planning strategies. New legislation or economic shifts can impact how 401(k) plans operate. Regularly consulting with your Wealth Manager or HR departments can ensure individuals remain up-to-date.

Required Minimum Distributions i.e. What You Have to Withdraw at Retirement

Required Minimum Distributions (RMDs) are amounts that retirees must withdraw from their 401(k) plans starting at a certain age, currently 72. The amount is calculated based on life expectancy and the account balance. 

Failing to take RMDs can result in significant tax penalties. While RMDs apply to traditional 401(k)s, Roth 401(k)s also have RMD rules unless rolled into a Roth IRA. Planning withdrawals strategically can help manage tax implications during retirement.

What to Do with Your 401(k) When You Switch Employers

When changing jobs, individuals have several options for their 401(k) funds. They can leave the money in the old employer’s plan, though they may no longer be able to contribute. Another option is to roll the funds into a new employer’s 401(k) or into an IRA. Cashing out is another choice but comes with potential penalties and tax implications. It’s crucial to weigh the pros and cons of each option and possibly consult with a Wealth Manager.

Common Questions about Retirement Planning and 401(k) Plans:

What is a good 401(k) amount to retire?

A good 401(k) amount to retire largely depends on individual lifestyle and expenses, but many financial experts suggest having 8-10 times your final salary saved by retirement age. The goal is to have sufficient funds to cover 70-85% of your pre-retirement income annually during your retirement years.

A 401(k) represents just one avenue among various account types available for pursuing your financial objectives, including taxable accounts and Roth accounts. Seeking guidance from a Wealth Manager to comprehensively assess and monitor the diverse assets you’re accumulating by type can be a prudent approach, ensuring you stay on track towards your retirement goals.

How much should I have in my 401(k) if I want to retire at 55?

If you aim to retire at 55, you should consider having saved at least 10-12 times your annual salary in your 401(k) by that age, given the earlier retirement age and potential for a longer retirement period. Early withdrawals before age 59½ may also incur penalties unless specific criteria are met.

How much will a 401(k) grow in 20 years?

The growth of a 401(k) over 20 years depends on the contribution amount, employer match, investment choices, and annual returns. Assuming an average annual return of 6-8%, your 401(k) can potentially double roughly every 9-12 years, depending on compounding frequency and market performance.

Is a 401(k) better than an IRA?

Both 401(k)s and IRAs offer unique advantages. A 401(k) often includes employer matches, allowing for higher total contributions, while an IRA may provide more investment options and flexibility. The best choice depends on individual needs, access to employer-sponsored plans, and financial goals.

Does a 401(k) gain interest?

A 401(k) doesn’t typically earn “interest” in the traditional sense. Instead, it earns returns based on the investments selected, such as stocks, bonds, or mutual funds. The returns can be in the form of dividends, capital gains, or interest from fixed-income investments.

Can I pull money out of my 401(k)?

Yes, you can withdraw money from your 401(k), but doing so before age 59½ often incurs a 10% early withdrawal penalty and the amount is subject to taxes. There are exceptions for specific situations like financial hardships, buying a home, or medical emergencies, but it’s essential to understand the rules and potential implications.

How 360 Financial Can Help You Plan for Retirement 

Unlock the future you envision with 360 Financial. With expert insights, financial planning tailored to your needs and goals, and a big-picture approach, we turn your work-optional dreams into actionable plans. Begin your journey to a secured, fulfilling retirement with the guidance of 360 Financial.

Work with a Financial Advisor Online or In Person

If you need a wealth management team to help you achieve your big-picture goals, we recommend scheduling a call with a financial advisor at 360 Financial.

360 Financial is one of Minnesota’s best independent wealth management firms. We work with clients in Minnesota and across the US. If you’d like to work with a team that always puts your best interests first and is committed to helping you create a lasting legacy, please get in touch. 

Schedule a 15-minute Call

About the Author

William Grant

Other Articles and Guides 

Minnesota Financial Planners

Financial Planning vs. Financial Advisor – What’s the Difference?

Schedule a Call

At 360 Financial, our clients come first. You deserve personalized attention. You’ll be happier and more confident in your financial future when you have an advisor who always puts your needs and best interest first. Schedule a 15-minute introductory call with a 360 financial advisor to see how we can help with your retirement, succession, tax, and estate planning.

Schedule a 15-minute Call

Financial Planning and Estate Planning in Minnesota

If you need financial planning assistance and a wealth management team to help you achieve your big-picture goals, we recommend scheduling a call with a financial advisor at 360 Financial.

360 Financial is one of Minnesota’s best independent wealth management firms. We work with clients in Minnesota and across the US. If you’d like to work with a team that always puts your best interests first and is committed to helping you create a lasting legacy, please get in touch.

This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.