How do 401Ks work?

A 401k is a type of retirement account that allows you to contribute pre-tax money, which means that your contribution is deducted from your paycheck and doesn't count as taxable income. Each year, you can contribute up to $19,000 (in 2019), or $18,500 if you're age 50 or older. In addition to benefiting from tax-deferred growth while saving for retirement, you'll also get an employer match on your contributions. That's right: Your employer might kick in extra funds based on how much money you deposit into your 401k plan each year! Here's what else you need to know about 401ks and how they work:

What is a 401k?

A 401(k) is a type of retirement plan that allows you to save money for retirement while getting tax benefits. It's sponsored by employers and is available to employees of companies with 401(k) plans. The employer manages the contributions made by employees, but not those made by their employers (if any).

How does a 401k work?

Once you've decided to participate in your company's 401k, your contributions will be deducted from your paycheck before taxes are taken out. Your employer may also match some of these contributions up to a certain percentage, depending on the company's generosity. You can invest in a variety of funds, including stocks and bonds; however, most people choose a combination of both. You have options when it comes time to invest:

• You can invest all of your money into one type of fund or spread it around several different funds.
• You can change your investment options at any time.
• You can withdraw money from your 401k at any time before age 59 1/2 without penalty (though there may be tax consequences).

How much can I contribute to my 401k?

The IRS limits the amount you can contribute to your 401k, but it varies according to your age, income and whether or not you are a participant in another retirement plan.

If you are age 50 or older, you may make catch-up contributions which allow you to contribute an additional $6,000 annually. For example, if you are 50 years old and have an annual salary of $100K per year, then your maximum contribution would be $50K ($18K from each paycheck).

The IRS allows for a maximum annual contribution equal to the lesser of:

• 100% of compensation or
• $19,000 (in 2019)

Catch up contributions for employees age 50 and older

If you're 50 years old or older, you may be able to contribute more than the standard $18,500 per year. For example, you can contribute up to $24,500 if your plan allows for catch-up contributions and your employer matches them at 100 percent.

Here are some details about the additional $6,000 in matching funds that some plans will allow:

You must be age 50 or older by December 31st of the year in which they want to make this type of contribution

The total amount contributed by both employee and employer cannot exceed $56,000 per person (as of 2019).

Maximum annual contributions to a 401k in 2020, 2021

If you're eligible to contribute, it's important to take advantage of the 401k maximums. These are the most you can contribute each year:

In 2019: $19,000

In 2020: $20,000 (for employees who were at least 50 years old at any time during the prior calendar year) or $25,000 (for employees who are 50 years old in 2020).

In 2021: $21,000 (for employees who were at least 50 years old at any time during the prior calendar year) or $26,500 (for employees who are 50 years old in 2021).

Advantages of investing in a 401k plan

A 401k plan can offer many benefits to individuals and businesses.

Tax-advantaged: First off, contributions to a 401k plan are tax-deferred. This means that you don’t have to pay taxes on any earnings until you withdraw those funds at retirement age. In addition, your employer may match some of your contributions with their own money in order to encourage employee participation in the plan.

Pre-tax contributions: Another advantage of a 401k is that it allows employees to make pre-tax contributions into their accounts through payroll deductions (instead of as after-tax income). For example, if an employee is making $50,000 per year in salary but only contributing 5% or $2,500 into a 401k plan each year due to other expenses such as rent or mortgage payments or childcare costs—and then contributes another $5,000 from post-tax earnings—that individual will end up paying much less tax overall than if they had taken out loans from banks instead of making pre-tax contributions towards their retirement savings goal!

Disadvantages of 401k plans

There are also a few downsides to 401k plans. One of these is that you can't access your money until you retire, which means that even if you need money for some reason, such as paying off student loans or taking care of an ill family member, it's not available to you. This is one reason why many people prefer Roth IRAs—they allow investors to withdraw funds without penalty at any point in their lives.

Another issue with 401ks is that once they're set up, people tend to stick with them until they retire instead of using other investment opportunities later on in life. For example, many Americans don't start investing in real estate until after college because they don't have the extra money available for investing; however, having investments outside of retirement savings accounts helps diversify portfolios and balance risk across several different types of assets (like stocks and bonds).

A 401k might be worth having if your employer matches it

For example, suppose you're eligible for a 401k at work and your employer matches 50% of what you contribute up to 6%. That means that if you contribute $100 into the plan, the company will match it with another $50.

Now let's say that you'll earn an 8% annual return on your investment—the amount of money your investments earn over a period of time. With this starting principal, and assuming no additional contributions (to keep things simple), after 10 years, your account would have grown by about $11,000 with only one year's worth of contributions.

Conclusion

Your employer may offer you the chance to invest in a 401k plan. If so, it’s worth taking advantage of this opportunity. The more money you can put away now, the better off you will be later on when you retire.