What Is a 401(k) Plan

What is a 401K

A 401(k) is a retirement savings and investing plan that employers can offer. The 401(k) plan gives employees a tax break on their contributions. Contributions are automatically withdrawn from employee paychecks and invested in funds of the employee’s choosing (from a list of available offerings). 401(k)s have a set amount that an employee can contribute annually. The annual contribution limit is $19,500 in 2021 and $20,500 for 2022 ($26,000 in 2021 and $27,000 in 2022 for those ages 50 or older). 

There is a specific reason these retirement savings accounts are referred to as 401(k)s. Its name comes from a tax code section, subsection 401(k), that established this type of plan. Depending on the type of plan, the tax break comes either when you contribute money out of your paycheck or withdraw it in retirement.

There is also the option of a Roth 401(k). With a Roth 401(k), contributions come out of your after-tax income, meaning they do not reduce your taxable income. Like a Roth individual retirement account (IRA), you pay no income taxes on qualified withdrawals, such as those made after the age of 59.

Key Factors of a 401(k) Plan

  • A 401(k) plan is a company-sponsored retirement account that employees can contribute towards, and their employers may match contributions.
  • There are two types of 401(k)s, a traditional and Roth, which differ when taxed.
  • With a traditional 401(k), employee contributions are pre-tax, meaning they reduce your taxable income, but they tax when you withdraw funds.

How does a 401k work

How to Enroll and How the Plan is Funded

First, your employer will approach you and ask you to complete the paperwork to sign up for their 401(k) plan. You then decide how much you want to contribute, and your employer puts the money into your account on your behalf. The money invested on your behalf is deducted from your paycheck. The IRS sets a maximum allowable contribution which employees can contribute up to $19,500 to their 401(k) plan for 2021 and $20,500 for 2022. 

Who Administers the Plan

Your employer sends your payroll deductions directly to the company managing your 401(k) plan, whom they have previously hired to manage the money on your behalf. But you are responsible for deciding how to invest your money among the options offered by your plan. Your employer may hire a mutual fund company, brokerage firm, or even an insurance company who will inform you on what options you have and where you can invest your funds. Typically, a 401(k) offers five or more mutual funds in various financial market sectors. 

The 401(k) funds investment is up to you, and you bear all the risk. You have to choose among the investment choices, usually mutual funds, that the plan offers. While your company may give you information about the funds, you’ll need to figure out which ones are best for you. 

What is a Matching Contribution?

Many companies offer matching contributions, which is when your employer sets up a percent or dollar amount, they will match your investment into the 401(k). The match can often be 50 cents to a dollar for every dollar you contribute, up to a set maximum – perhaps 3% to 6% of your salary, or in some cases a dollar limit. The match is free money! And it effectively increases your income without increasing your tax bill since you pay no taxes on matching contributions until you withdraw them in retirement.

The employer’s match money typically “vests” over three or four years, meaning you have to keep working for the company for that amount of time before all the matching funds are yours to keep

How does Vesting Work?

Any money you contribute from your paycheck into your 401(k) is always 100% yours. But company matching funds usually vest over time, typically either 25% or 33% a year, or all at once after three or four years. Once you’re fully vested, you can take the entire company match with you when you part ways with your job. If you’re not fully vested, you’ll get to keep only a portion of the match or maybe none at all. Check with your company’s benefits administrator to find out your vesting schedule.

For example, you have invested $20,000 into your company’s 401(k) over 4 years, and they have matched 50% of that. According to your company’s administrator, you get 20% of your employer’s contribution a year until 5 years when you are fully vested. When you leave that employer at 4 years, you will take your $20,000 investment, and $8,000 of the $10,000 employer contribution will be yours. $2,000 of the employer’s contribution will not be yours to take since you have not become fully vested at the 5-year mark. 

What are the benefits of a 401k?

There are many benefits to investing in your company’s 401(k). The main benefit of 401(k) plans is that they allow retirement savings to grow tax-deferred. But there are more advantages, especially compared to individual retirement accounts (IRAs). Read on for some of these less-known 401(k) benefits.

Tax Benefits

First, as explained above, contributions are pre-tax. You don’t pay taxes on the money until you withdraw it when you retire. At the earliest, this is age 59.5. Second, your contributions could put you in a lower tax bracket by not being counted as income. This can result in a smaller tax bill, just for your having put away money for retirement.

Third, your savings grow tax-deferred. Your net gains and dividends are taxed in a regular investment account. But in a 401(k) plan, your money grows tax-free as long as it stays in the plan. This allows your earnings to earn earnings – or compound as a financial advisor says. You’ll owe taxes, of course, once you withdraw the money.

401(k) Company Match Benefits

As discussed above, many employers offer to match employee contributions, either dollar for dollar or 50 cents to the dollar, up to a set limit. They do this to encourage people to sign up for the plan, which, as noted earlier, is voluntary. Company matches are also a good perk for attracting and retaining talent. (The IRS allows companies to set periods of up to five years before matches are fully vested.) Whatever a company’s reason for offering a match, it is free money that you wouldn’t otherwise get. And like employee contributions, they are tax-deferred, and the earnings are tax-deferred.

401(k) Late Saver Benefits

Many people put off saving for retirement until later in life or may not have had the opportunity to put into a 401k with previous employers. Whatever the reason, there is an opportunity that allows them to catch up. To help all of the late savers out there, the government enables annual catch-up contributions of $6,500 to 401(k) plans by people who are age 50 or older. That’s in addition to the regular allowed employee contribution of up to $20,500 for 2022 (or $19,500 for 2021). This is considerably more than the $6,000 annual contribution and $1,000 catch-up you can put in an IRA.

401(k) Fiduciary Benefits

Because 401(k) plans fall under the Employee Retirement Income Security ERISA Act, employers are responsible for ensuring that participants’ best interests are put first. In other words, the plan administrators are held to a fiduciary standard. This means that though costs don’t have to be the lowest available, they must be reasonable. Similarly, the investment options must be stable. Also, essential information such as fees has to be disclosed.

Types of 401k

Employers can choose from several options when offering employees 401(k) plans. Those plans include the Traditional 401(k) plans, Roth 401(k)s, Safe harbor 401(k) plans, and SIMPLE 401(k)s. If you run a business of your own, you can also choose to set up a solo 401(k) for yourself. 

The Employer-sponsored plans must adhere to IRS Rules regarding contribution limits, but they can also have their own rules when it comes to things like:

  • Employee eligibility
  • Waiting periods and enrollment
  • Investment selection
  • Matching contributions

Traditional 401(k) plans

  • Public or private employers of any size can offer them.
  • Employees contribute pre-tax dollars through elective salary deferrals.
  • Contributions reduce taxable income for the year.
  • Employers can offer matching contributions.
  • Qualified withdrawals are taxed at your ordinary-income tax rate.

Roth 401(k) Plans

  • Public or private employers of any size can offer them
  • Employees contribute after-tax dollars through elective salary deferrals
  • Contributions do not reduce taxable income for the year
  • Employers can provide matching contributions
  • Qualified withdrawals are generally tax-free

Safe Harbor 401(k) Plans

  • Public or private employers of any size can offer them
  • Employers are required to contribute to each employee’s plan, either on a matching or nonelective basis
  • Employer contributions are required to be fully vested and guaranteed to employees
  • Employees can make contributions up to the annual limits set by the IRS
  • Employee contributions are deducted from taxable income
  • Qualified withdrawals are taxed at ordinary income rates

SIMPLE 401(k) Plans

  • Businesses with 100 or fewer employees can offer them
  • Employees can make contributions up to the annual limits set by the IRS
  • Employee contributions are made using pre-tax dollars
  • Employers must also contribute to employee plans
  • Qualified withdrawals are taxed at ordinary income rates

Withdrawing funds from your 401(k)

Unexpected bills, auto accidents, or illness can occur, and many consider turning to their 401(K) plans to withdraw money. 401(k)s allow early withdrawal, but with penalties, so it is best to consider your options before making a decision. 

Taking a withdrawal from your traditional 401(k) should be your last resort as any withdrawals before age 59 ½ will be taxed as income by the IRS, plus a 10 percent early withdrawal penalty to the IRS. This penalty was put into place to discourage people from dipping into their retirement accounts early.

Roth contribution withdrawals are tax and penalty-free (as long as the withdrawal occurs at least five years after the tax year in which you first made a Roth 401(k) contribution, and you’re 59 ½ or older). This is because the dollars you contribute are after-tax. 

Be careful because the five-year rule supersedes the age 59 ½ rule that applies to traditional 401(k) distributions. If you didn’t start contributing to a Roth until age 60, you would not be able to withdraw funds tax-free for five years, even though you are older than 59 ½.

How do you get a 401(k)?

Many people get their 401(k) plans through their employer, so ask your human resources department if you qualify for your company’s 401(K). 

For those who are self-employed and unable to get employer-sponsored 401(k), there are Solo 401(K) plans. Solo 401(K) plans are designed for business owners and self-employed individuals with no employees other than their spouses. Here’s how these plans work:

Solo 401(K) Plans

  • Available to sole proprietors, self-employed individuals, and small business owners who employ no one other than their spouses
  • Plan owners can make contributions as an employer and an employee.
  • Contributions are tax-deductible
  • Qualified withdrawals are taxed as ordinary income.

If you are not sure if your employer offers a 401(k), ask your human resources department if you qualify.

Alternatives to 401(k)?

Fortunately, the 401(k) isn’t the only way to save for retirement. You have options ranging from tax-advantaged accounts to taxable investments that can grow in value over time. We will review a few of these options below.

  1. Roth IRA is a retirement investment account funded with after-tax dollars. You don’t get a tax deduction on your contributions, but qualified withdrawals in retirement are tax-free. Your investment earnings are also tax-free if you follow the withdrawal rules. You can withdraw your contributions from a Roth IRA at any time. To avoid taxes and penalties when you withdraw earnings from a Roth IRA, you must be 59½ years of age or older. 
  2. SEP-IRA is a retirement investment account designed for small business owners and the self-employed. Your business funds your SEP-IRA contributions, and they are tax-deductible if you’re self-employed. The contribution limits are very high, but no extra catch-up contributions can be made when you turn 50. Qualified SEP-IRA withdrawals in retirement are taxable as ordinary income. Early withdrawals before the age 59 1/2 are subject to taxes and penalties unless you are eligible for an exception.
  3. A Health Savings Account, or HSA, is an investment account that helps you pay for medical expenses. You are only eligible for an HSA if you have a high-deductible health plan. HSA contributions are tax-deductible, and investment earnings are tax-deferred. You can take tax-free withdrawals from your HSA at any age to pay for medical expenses. Non-medical withdrawals are subject to taxes and a 20% penalty until age 65. After your 65th birthday, the penalty goes away, and you’ll only pay taxes on non-medical HSA withdrawals.

FAQ

What happens to my 401k if I change jobs? 

  • If you change companies, you can roll over your 401(k) into your new employer’s plan if the new company has one.
  • Another option is to roll over your 401(k) into an individual retirement account (IRA).
  • You can leave your 401(k) with your former employer if your account balance isn’t too small.
  • Another choice is cashing it out, but there will be the standard penalties if you do this, so that should always be your last option.

What are the penalties if I cash out my 401k early?

  • If you are under age 59½, in most cases, you will incur a 10% early withdrawal penalty and owe regular income taxes on the amount taken out.
  • Under certain limited circumstances, a withdrawal without penalty is permitted, but income taxes will still be due on the withdrawal.
  • A better option may be to take out a loan from your 401(k) and repay it over time with a payroll deduction.

Can I contribute 100% of my salary to my 401k?

Yes, if the 401(k) plan permits participants to make contributions up to 100% of their yearly salary. There are also limits the IRS places on maximum annual contributions, as we discussed above. This would need to be addressed with your plan administrator to review your company’s 401(k) guidelines.

Summary

You finally decided to talk to your employer about the 401k plans available. But you’re not sure what questions to ask, so we cover all the bases in What is a 401(k). We discuss the rules and regulations involved with a 401(K), along with the many benefits they offer.

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