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The 401(k) plan has become the most popular type of employer-sponsored retirement plan in America since its inception in 1978. Few other plans can match the relative flexibility of the 401(k). There are rules to follow, however, because you’re getting tax breaks from the federal government in return for investing for retirement.
Millions of workers depend on the money they invest in these plans to provide for them in their retirement years and, for many, it’s a key benefit of the job.
Key Takeaways
- A 401(k) is a qualified retirement plan, which means it is eligible for special tax benefits.
- You can invest a portion of your salary up to an annual limit.
- Your employer may or may not match part of your contribution.
- The money will be invested for your retirement, usually in your choice of several mutual funds.
- With a few exceptions, you can’t withdraw money without paying a tax penalty until you’re 59½.
What Is a 401(k) Plan?
A 401(k) plan is a retirement savings account that allows an employee to divert a portion of each paycheck salary into long-term investments. The employer may match part of the employee’s contribution as a job benefit.
A 401(k) is technically a qualified retirement plan, meaning it is eligible for special tax treatment under Internal Revenue Service (IRS) guidelines.
Defined Contribution Vs. Defined Benefit
Qualified retirement plans come in two versions. They may be either defined contribution plans or defined benefit plans, such as a pension.
The 401(k) plan is a defined contribution plan. That means the employee manages the fund and chooses the investments. When the employee retires, the account balance is theirs to use as they see fit.
(A defined benefit plan, such as a pension, is managed by the employer and guarantees a lifetime payment based on the person’s salary history.)
In a traditional 401(k) plan, the money that the employee pays into the 401(k) is tax-deferred. No income taxes will be due until the money is withdrawn. The earnings are not taxed until they’re used either.
The Roth 401(k) Variation
Not all employers offer it, but the Roth 401(k) is an increasingly popular variation of the traditional 401(k) plan.
If you have a Roth plan, you’ll pay income taxes on the money you pay into your fund. When you withdraw it after you retire, no further taxes will be due on the principal or the earnings.
Important
Employer contributions can only go into a traditional 401(k) account, not a Roth.
401(k) Contributions
The maximum amount of salary that an employee can defer to a 401(k) plan, whether traditional or Roth, changes annually. Employees aged 50 and older can make additional catch-up contributions to boost their savings.
Contributions to a traditional 401(k) are made with pre-tax dollars and reduce the employee’s taxable income as well as adjusted gross income (AGI). Taxes are deferred until the funds are withdrawn.
Important
The maximum joint contribution between employee and employer cannot exceed the employee’s total annual compensation.
Limits for High Earners
For most people, the contribution limits on 401(k)s are high enough to allow for adequate levels of income deferral. However, there is a cap for highly paid earners, which changes annually as well.
401(k) Investment Options
A company that offers a 401(k) plan typically offers employees a choice of several investment options. The options are usually managed by a financial services advisory group such as The Vanguard Group or Fidelity Investments.
The employee can choose one or several funds to invest in. Most of the options are mutual funds, and they may include index funds, large-cap and small-cap funds, foreign funds, real estate funds, and bond funds.
They usually range from aggressive growth funds to conservative income funds. You can adjust your investing strategy from time to time, moving your money to more aggressive or more conservative choices.
Rules for Withdrawing Money
The distribution rules for 401(k) plans differ from those that apply to individual retirement accounts(IRAs), which are not company-sponsored but are available from banks and investment companies.
In either case, an early withdrawal of assets will mean income taxes are due. With few exceptions, a 10% additional tax penalty will be levied on those younger than 59½.
Triggering Events
But while an IRA withdrawal doesn’t require a rationale, a triggering event must be satisfied to receive a payout from a 401(k) plan. The following are the usual triggering events:
- The employee retires or leaves the job.
- The employee dies or is disabled.
- The employee reaches age 59½.
- The employee experiences a specific hardship as defined under the plan.
- The plan is terminated.
Money withdrawn from a 401(k) is usually taxed as ordinary income.
Depending on your company’s rules, you may also be able to take a loan from your 401(k), paying yourself back over time.
Post-Retirement Rules
Account owners who turned 73 on or after Jan. 1, 2023, must begin taking required minimum distributions (RMDs) at age 73 unless they still work for the sponsoring employer and have a plan that allows them to defer RMDs.
The age for RMDs has been raised a couple of times in the past and may well be raised again.
Fast Fact
The rules for RMDs differ among retirement accounts. Even if you’re still employed, you have to take the RMD from a traditional, SEP, or SIMPLE IRA, for example.
The Rollover Option
Retirees may choose to transfer the balance of their 401(k) plans to a traditional IRA or a Roth IRA. This rollover gets them access to a broader array of investment choices than employers usually offer for 401(k) accounts.
If you decide to do a rollover, make sure you do it right. In a direct rollover, the money goes straight from the old account to the new account and there are no tax implications. In an indirect rollover, the money is sent to you first, and you will owe the full income taxes on the balance in that tax year.
If your 401(k) plan has employer stock in it, you are eligible to take advantage of the net unrealized appreciation (NUA) rule and receive capital gains treatment on the earnings. That will lower your tax bill significantly.
Warning
To avoid penalties and taxes, a rollover must take place within 60 days of withdrawing funds from the original account. Your wisest choice is to get your money sent directly from your former account administrator to the new account administrator.
401(k) Plan Loans
If your employer permits it, you may be able to take a loan from your 401(k) plan. If this option is allowed, up to 50% of the vested balance can be borrowed up to a certain amount. The borrower must repay the loan within five years. A longer repayment period is allowed for a primary home purchase.
In most cases, the interest paid will be less than the interest on a bank or consumer loan and you’ll be paying it to yourself. But be aware that any unpaid balance will be considered a distribution and taxed and penalized accordingly.
In addition, should you leave your employer, you will be required to pay any pending 401(k) loan balance in full or face IRS tax or penalties.
Hardship Distributions
Emergencies happen. And you may find that the only place you can turn to meet your immediate financial needs is your retirement plan. While it may not necessarily be the best route, you have the option to take a hardship distribution or withdrawal.
Several considerations come into play with this kind of withdrawal:
- There must be a clear and present need to take a hardship distribution. It can also be a voluntary or foreseeable need as long as it is reasonable.
- The amount of the withdrawal must not exceed the need.
- You can’t take any elective distributions for six months after the hardship withdrawal.
This type of withdrawal is taxable. Full details on hardship distributions are available through the IRS website.
401(k) Strategies
No single retirement strategy is best for everyone but some tips benefit most investors, especially those looking to make the most of their retirement savings.
Maximize Employer Match
One of the golden rules of retirement savings is to contribute at least enough money to take full advantage of your employer match.
For example, if your employer matches dollar for dollar your first 4% of 401(k) contributions, you should strive to put at least 4% into your 401(k).
This strategy maximizes the free money you receive from your employer.
Be Mindful of Contribution Limits
The IRS does not permit contributions that exceed its annual 401(k) limits. Should you overcontribute, you are required to then withdraw those excess contributions, triggering taxes and penalties.
Compare Roth and Traditional 401(k) Benefits
In general, it is better to contribute to a Roth account if your tax bracket is currently low and you expect to be higher in the future. It is usually better to contribute to a traditional account when your tax bracket is currently high.
This is a personal financial decision. A Roth account is a little more painful upfront in exchange for a lot of gain down the road. That is, you get no immediate tax break and no reduction in your annual taxable income. But when you withdraw the money after retiring, you’ll owe no taxes on that income.
Avoid Early Withdrawals
Should you withdraw retirement plan funds early, in most cases, you will be subject to federal income tax on the withdrawal plus pay a 10% penalty.
The withdrawal also will damage the compounding effect your investments experience over time. Leaving your 401(k) plan as-is for longer maximizes your potential for long-term portfolio growth.
How Do I Start a 401(k)?
If you work for an employer who has a 401(k) plan, you should get information on the plan and how to sign up for it as soon as you start the job. Your pay stub will reflect your contribution as soon as you’re enrolled.
A 401(k) plan can only be offered through an employer. If you’re self-employed or a freelancer, consider opening an IRA for your retirement savings. Many are available through banks and investment companies, so you can pick and choose the type of IRA you want.
What Benefits Does a Traditional 401(k) Plan Offer?
Making your contributions through payroll deductions is a no-fuss, no-muss process.
You’re deferring income taxes on that money and lowering your taxable income, year after year. Meanwhile, the money should be piling up nicely until you retire.
If your employer provides a contribution match, it sweetens the pot.
The earlier you start investing, the more your savings compound. Even if you change employers, you can take your account with you.
What’s the Difference Between a Traditional 401(k) and a Roth 401(k)?
While traditional 401(k) plans allow you to make pre-tax contributions, the Roth version requires after-tax contributions.
The Roth tax benefit occurs when you make withdrawals from your account. That money is tax-free.
Withdrawals from traditional accounts will be taxed at your income tax rate.
The Bottom Line
Saving for retirement should be on your radar if you hope to maintain the same lifestyle you currently have. But with so many options, where do you start? The best place is the 401(k) plan, which is offered by employers.
If your company has this plan, take advantage of it. This is even more important if your employer matches contributions.
But it isn’t just about saving money. Knowing the ins and outs and the rules associated with the plan can make you a better investor.
