What Is a 401(k) Plan and How Does It Work?
A 401(k) plan is a tax-advantaged retirement savings plan that is offered by many American workplaces. It is called after a provision of the Internal Revenue Code of the United States.
When an employee enrolls in a 401(k), he or she agrees to have a portion of each paycheck deposited directly into an investing account. Part or all of the contribution may be matched by the employer. The employee has a variety of investment options to select from, most of which are mutual funds.
Important Points to Remember
- A 401(k) plan is a company-sponsored retirement account to which employees can contribute money and which their employers may match.
- Traditional and Roth 401(k)s are the two most common varieties, and they differ principally in how they are taxed.
- Employee contributions to a standard 401(k) are “pre-tax,” meaning they lower taxable income, but withdrawals are taxed.
- Employees contribute after-tax income to Roth 401(k)s; there is no tax deduction in the year of contribution, but withdrawals are tax-free.
- The CARES Act reduced the withdrawal restrictions for persons impacted by the COVID-19 pandemic in 2020, and RMDs were suspended.
The 401K: An Overview (K)
The United States Congress created the 401(k) plan to encourage Americans to save for retirement. One of the advantages they provide is tax savings.
There are two main choices, each with its own set of tax benefits:
Traditional 401(k) plans (k)
Employee contributions to a standard 401(k) are taken from gross income, which means the money comes from the employee’s paycheck before income taxes are subtracted. As a result, the total amount of contributions for the year is deducted from the employee’s taxable income, which can then be recorded as a tax deduction for that tax year. There are no taxes due on the money donated or earned until the employee withdraws it, which is usually in retirement.
401(k) Roth (k)
Contributions to a Roth 401(k) are deducted from the employee’s after-tax income, which means contributions are taken from the employee’s compensation after taxes have been deducted. As a result, no tax deduction is available in the year of contribution. There are no additional taxes required on the employee’s contribution or the investment earnings when the money is withdrawn at retirement.
However, Roth accounts are not available at all employers.
If the Roth is available, the employee can choose one or the other, or a combination of the two, up to the yearly tax-deductible contribution limitations.
Investing in a 401(k) Plan
A 401(k) is a type of defined contribution retirement plan. Contributions to the account can be made by both the employee and the employer up to the financial restrictions imposed by the Internal Revenue Service (IRS).
A defined contribution plan, also termed as a defined-benefit plan by the IRS, is an alternative to the traditional pension. With a pension, the company agrees to pay the employee a set sum of money for the rest of his or her life.
Employers have moved the duty and risk of saving for retirement to their employees, resulting in the rise of 401(k) plans and the decline of traditional pensions in recent decades.
Employees are also responsible for selecting specific investments for their 401(k) accounts from a list provided by their company. Those options usually include a mix of stock and bond mutual funds, as well as target-date funds, which are meant to decrease the risk of investment losses as the employee nears retirement.
Guaranteed investment contracts (GICs) issued by insurance firms, as well as the employer’s own stock, may be included.
Limitations on Contribution
The maximum amount that an individual or company can contribute to a 401(k) plan is increased on a regular basis to account for inflation, which is a metric that monitors an economy’s rising prices.
Employee contributions are capped at $19,500 per year for workers under the age of 50 in 2021, and $20,500 per year in 2022. In 2021 and 2022, however, persons aged 50 and older can make a $6,500 catch-up contribution.
There is a total employee-and-employer contribution amount for the year if the employer contributes as well, or if the employee elects to make additional, non-deductible after-tax payments to their standard 401(k) account.
The combined employee-and-employer contribution amount for workers under 50 years old is capped at $58,000, or 100 percent of employee compensation, whichever is lesser.
The maximum rises to $64,500 if we include the catch-up payment for people aged 50 and up.
The total employee-employer contributions for workers under the age of 50 cannot exceed $61,000 per year.
The total ceiling, including the catch-up payment for individuals over 50, is $67,500.
Employers who match their employees’ contributions utilize a variety of formulas to do so.
An employer might, for example, match 50 cents for every dollar an employee puts in up to a particular percentage of compensation.
Employees should contribute enough to their 401(k) plans to receive the full employer match, according to financial gurus.
Investing in a Traditional and Roth 401(k) (k)
Employees who work for a company that offers both types of 401(k) plans can split their contributions, putting some in a standard 401(k) and some in a Roth 401(k) (k).
Their combined contributions to the two types of accounts, however, cannot exceed the limit for one account (for example, $19,500 for those under 50 in 2021 and $20,500 in 2022).
Employer contributions can only be made to a standard 401(k) account, which will be taxed when withdrawn, and not to a Roth account.
Withdrawals from a 401(k) (k)
It’s tough to withdraw money from a 401(k) without paying taxes on the withdrawal amounts.
“Make sure you have enough money saved up for emergencies and unexpected needs before retiring,” says Dan Stewart, CFA®, president of Dallas-based Revere Asset Management Inc. “Don’t put all of your savings into a 401(k) where you won’t be able to retrieve it quickly if you need it.”
Traditional 401(k) account profits are tax-deferred, whereas Roth 401(k) account earnings are tax-free. When a typical 401(k) owner takes a distribution, the money will be taxed as regular income, even though it has never been taxed. Owners of Roth accounts have previously paid income tax on their contributions and will owe no tax on any withdrawals as long as they meet specific criteria.
When it comes to withdrawals, both traditional and Roth 401(k) owners must be at least 5912 years old—or meet other IRS requirements, such as being totally and permanently handicapped.
If they don’t, they’ll normally have to pay a 10% early-distribution penalty tax on top of any other taxes they owe.
Some firms allow employees to borrow money against their 401(k) contributions. The employee is essentially taking out a loan from himself. If you take out a 401(k) loan, keep in mind that if you quit your employment before the loan is repaid, you’ll have to refund it in full or suffer a 10% early withdrawal penalty.
Minimum Distributions Requirements
RMDs, or required minimum distributions, are required of traditional 401(k) account holders after they reach a specific age. (In IRS jargon, withdrawals are referred to as “distributions.”)
Account owners who have retired after the age of 72 are required to take at least a certain amount from their 401(k) plans, based on IRS tables based on their life expectancy at the time. (The RMD was 7012 years old prior to 2020.)
It’s worth noting that typical 401(k) distributions are taxable. Withdrawals from a Roth 401(k) are not qualified.
Unlike Roth 401(k)s, Roth IRAs are not subject to required minimum distributions (RMDs) during the owner’s lifetime.
Roth 401(k) vs. traditional 401(k) (k)
When 401(k) plans first became available in 1978, employers and workers only had one option: the typical 401(k) plan (k). Then, in 2006, Roth 401(k)s were available. Former United States Senator William Roth of Delaware was the major sponsor of the 1997 legislation that established the Roth IRA.
While Roth 401(k)s were slow to catch on, they are now widely available. As a result, employees frequently have to choose between Roth and traditional retirement plans.
Employees who expect to be in a lower marginal tax band after retirement should generally choose a regular 401(k) to take advantage of the immediate tax savings.
Employees who expect to be in a higher tax bracket after retirement, on the other hand, may choose the Roth to avoid paying taxes on their funds later. Also important—especially if the Roth has years to grow—is that there is no tax on withdrawals, which means that all of the money contributed grows tax-free over decades.
In practice, a Roth 401(k) plan lowers your immediate spending power more than a standard 401(k). If you’re on a tight budget, this is important.
Because no one knows what tax rates will be in the future, neither sort of 401(k) is guaranteed. As a result, many financial gurus advise clients to hedge their bets by investing a portion of their money in each.
When You Decide to Leave Your Job
When an employee leaves a firm with a 401(k) plan, he or she usually has four options:
1. Take your money out.
Withdrawing money is rarely a good idea unless the employee has a pressing need for cash. The funds will be subject to taxation in the year they are withdrawn. Unless the employee is over 5912, permanently incapacitated, or meets other IRS criteria for an exception to the provision, the employee will be subject to an additional 10% early distribution tax.
For people afflicted by the COVID-19 economic crisis in 2020, this rule has been suspended.
Employee contributions (but not profits) in Roth IRAs can be withdrawn tax-free and penalty-free at any time as long as the employee has had the account for at least five years. They’re still depleting their retirement funds, something they may come to regret later.
2. Convert your 401(k) to an Individual Retirement Account (IRA).
The employee can avoid immediate taxes and keep the account’s tax-advantaged status by transferring the funds to an IRA at a brokerage firm, mutual fund company, or bank. Furthermore, the employee will have access to a broader selection of investment options than they would with their employer’s plan.
The IRS has quite tight guidelines about rollovers and how they must be completed, and breaking them can be costly. Typically, the financial institution in line to receive the funds will be more than willing to assist with the procedure and ensure that no mistakes are made.
To avoid taxes and penalties, funds withdrawn from your 401(k) must be rolled over to another retirement plan within 60 days.
3. Keep your 401(k) with your previous employer.
Employers will often allow a departing employee to keep a 401(k) account in their former plan indefinitely, even though the individual is no longer eligible to contribute to it. This usually applies to accounts with a balance of $5,000 or more. In the event of smaller accounts, the employer may force the employee to transfer the funds to another account.
If the old employer’s 401(k) plan is well-managed and the employee is content with the investment options, leaving the money where it is can make sense. Employees who move jobs throughout their careers run the risk of leaving a trail of old 401(k) plans behind them and forgetting about one or more of them. Their successors may similarly be unaware of the accounts’ existence.
4. Transfer Your 401(k) to a New Company
Your 401(k) balance can normally be transferred to your new employer’s plan. This, like an IRA rollover, keeps the account tax-deferred and avoids paying taxes right away.
If the employee isn’t comfortable making the financial decisions that come with administering a rollover IRA and would rather delegate part of that work to the new plan’s administrator, this could be a smart move.
How Does a 401(k) Plan Work?
A 401(k) Plan is a type of retirement savings plan that allows employees to put a percentage of their paycheck into a long-term investing account. The employer may also make a financial contribution.
If the account is a standard 401(k), the employee receives immediate tax benefits, and if the account is a Roth 401(k), the employee receives tax benefits after retirement (k).
If it is a typical 401(k), the money earned in the account will not be taxed until it is taken after retirement (k). When money is withdrawn from a Roth 401(k), no taxes will be owed.
Is It Beneficial to Have a 401(k) Plan?
401(k) plans are a terrific tool for employees to invest for retirement in general. They make it simple to save because the money is deducted automatically. They provide tax benefits to the saver. Furthermore, some employers match employee contributions.
Employees have more to gain from participating in a 401(k) plan if their employer matches their contributions, assuming all other factors are equal.
What Percentage of My Salary Can I Put Into a 401(k) Plan?
Each year, the maximum amount an employee can contribute to their 401(k) Plan is raised to keep up with inflation. Workers under the age of 50 will be able to earn $19,500 per year in 2021, while those above 50 would be able to earn $26,000. Workers under the age of 50 will be able to earn $20,500 a year in 2022, while those beyond the age of 50 would be able to earn $26,500.
If an employee receives matching contributions from their employer, the total contribution from both the employee and the employer is capped at the lesser of $58,000 in 2021 or 100% of the employee’s annual pay (the cap is $61,000 in 2022).