A 401K plan is one of the most popular ways that people who are employed use to save money for retirement. This type of plan is employer-sponsored, and it allows workers to direct a portion of their pay into an account that grows on a tax-deferred basis.
Later in life, seniors can use the money these accounts to provide retirement income. 401K plans are complex, though, and there are certain things for seniors to keep in mind in order to use them most effectively.
How Does a 401K Work?
As we established earlier, a 401K is a type of employer-sponsored plan that individuals use to save money for retirement. To take part in their employer’s plan, an employee will show what percentage of their salary they would like to contribute. Many employers offer a contribution match, so for every dollar an employee saves, the employer will contribute the same amount–usually, up to a stated limit.
Choosing a Plan
Employees also choose the type of plan they would like to use. Many employers offer traditional and Roth plans. In a traditional plan, contributions are pre-tax. This means that employees get to deduct their plan contributions from their taxable income in the year you make the contributions–saving on income taxes now. Later, when withdrawals are taken, they are fully taxable.
Roth plans work a little differently; contributions are not tax-deductible, but, subject to certain limits, withdrawals after age 59 ½ are completely tax-free. So, the employee gets to decide whether they want to save on taxes now or later.
Stocks and Bonds
The next thing to consider is the available menu of investment options. The employer selects type of bond, and the selection usually consists of mutual funds in stocks, bonds, or money markets. If the employer is a public company, they may also allow employees to allocate their contributions into company stock.
One of the most attractive features of a 401K is that earnings from the underlying investments accrue on a tax-deferred basis. Whether the investments grow in market value or pay dividends or interest, no taxes are due. The only way taxes are due is unless money is taken from the account.
How Your Plan Works
A person’s employment status also contributes to how their plan works. Generally, if a person stops working for the employer who sponsors their plan, they can no longer contribute to that plan. They can, however, roll the proceeds of that plan into an individual retirement account (IRA), where they can keep contributing.
Later in life, when most people are seniors (or approaching that time), the focus may shift from growing retirement assets to drawing upon them as an income stream.
When to Withdraw?
As with most financial matters, the best time to withdraw money from a 401K depends on a person’s individual situation. An important thing to remember is that withdrawals prior to age 59 are subject to a 10% IRS penalty plus the income tax. There are a few scenarios in which the 10% penalty will be waived, though. These include disability, certain medical expenses, and distributions made to a beneficiary after the account owner passes away.
With this in mind, most seniors find it best to wait until age 59 at least to cash out. Another consideration is a person’s tax bracket. In a traditional plan, distributions are fully taxable at a person’s income tax rate. This is usually less of a consideration for Roth plans.
Investing For Retirement
Another consideration is the performance of the assets in the account. When the market is doing well and there is a lot of gain in the account, it might be a good time to consider taking money out. Taking money out means that there might be some losses incurred. This scenario played out for many seniors in the wake of the last financial crisis. Unfortunately, market risk is an unavoidable reality for seniors investing for retirement.