What is a 401(k) plan?
A 401(k) plan is a retirement savings plan offered by many US employers that has tax benefits to the saver. It is named after a section of the US Internal Revenue Code.
An employee who signs up for a 401(k) agrees to pay a percentage of each paycheck directly into an investment account. The employer may reconcile part or all of that contribution. The employee gets to choose from several investment options, usually mutual funds.
- A 401(k) plan is a company-sponsored retirement account to which employees can contribute income, while employers can match contributions.
- There are two basic types of 401(k)s—traditional and Roth—that differ primarily in how they are taxed.
- With a traditional 401(k), employee contributions are “pre-tax,” meaning they reduce taxable income, but withdrawals are taxed.
- Employee contributions to Roth 401(k)s are made with after-tax income; There are no tax deductions in the contribution year, but withdrawals are tax-free.
- For 2020, under the CARES Act, evacuation rules for those affected by the COVID-19 pandemic were relaxed, and RMDs suspended.
How 401(k) Plans Work
The 401(k) plan was designed by the United States Congress to encourage Americans to save for retirement. Among the benefits they provide are tax savings.
There are two main options, each with different tax benefits:
With a traditional 401(k), employee contributions are deducted from gross income, meaning the money comes from the employee’s payroll. before this Income tax has been deducted. As a result, the employee’s taxable income is reduced by the total amount of contributions for the year and can be reported as a tax deduction for that tax year. Contributed money or earnings are not taxed until the employee withdraws the money, usually in retirement.
With a Roth 401(k), contributions are deducted from the employee’s after-tax income, meaning the contribution comes from the employee’s salary. after Income tax has been deducted. As a result, there is no tax deduction in the year of contribution. When the money is withdrawn during retirement, there is no additional tax on the employee’s contributions or investment income.
However, not all employers offer the option of a Roth account. If a Roth is offered, the employee can choose to have one or the other, or a mixture of both, up to the annual limit on his or her tax-deductible contributions.
Contribution to a 401(k) Plan
A 401(k) is a defined contribution plan. Employees and employers can contribute to the account up to the dollar limit set by the Internal Revenue Service (IRS).
A defined contribution plan is an alternative to a traditional pension, known in IRS lingo as a defined-benefit plan. With pension, the employer is committed to provide a specific amount for life to the employee during retirement.
In recent decades, 401(k) plans have become more common, and traditional pensions have become scarce as employers transfer the responsibility and risk of saving for retirement to their employees.
Employees are also responsible for choosing specific investments within their 401(k) accounts from a selection provided by their employer. Those offerings typically include stock and bond mutual funds and target-date funds that are designed to reduce the risk of investment losses as the employee approaches retirement.
These can include guaranteed investment contracts (GICs) issued by insurance companies and sometimes the employer’s own stock.
The contributions an employee or employer can make to a 401(k) plan are adjusted periodically for inflation, which is a metric that measures rising prices in an economy.
For 2021, the annual limit for employee contributions is $19,500 per year for workers under the age of 50, and for 2022, the limit is $20,500 per year. However, people age 50 and older can make a catch-up contribution of $6,500 in 2021 and 2022.
If the employer also makes contributions, or if the employee elects to make additional, non-deductible after-tax contributions to his traditional 401(k) account, the total employee-and-employer contribution amount for the year is.
- For workers under age 50, the total employee and employer contribution amount is limited to $58,000, or 100% of employee compensation, whichever is less.
- If we include catch-up contributions for those 50 and over, the limit is $64,500.
- For workers under age 50, the total employee-employer contribution cannot exceed $61,000 per year.
- For those 50 and over, the limit is $67,500, including catch-up contributions.
Employers who match their employee contributions use a variety of formulas to calculate that match.
For example, an employer may match 50 cents for every dollar that employee contributes up to a certain percentage of salary.
Financial advisors often recommend that employees contribute at least enough money to their 401(k) plans to receive the full employer match.
Contribution to both traditional and Roth 401(k)s
If their employer offers both types of 401(k) plans, employees can split their contributions, putting some money into a traditional 401(k) and some into a Roth 401(k).
However, their total contributions in the two types of accounts cannot exceed the limit of one account (such as $19,500 for those under 50 in 2021 and $20,500 for 2022).
Employer contributions can only go into a traditional 401(k) account where they will be subject to tax on withdrawals, not a Roth.
Taking Withdrawals from a 401(k)
Once money goes into a 401(k), it is difficult to withdraw it without paying taxes on the withdrawal amount.
“Make sure you still save enough for emergencies and pre-retirement expenses,” says Dan Stewart, CFA®, president of Revere Asset Management Inc. in Dallas. “Don’t put all your savings in your 401(k) where you can’t easily access it, if necessary.”
Income in a 401(k) account is tax-deferred in the case of traditional 401(k)s and tax-free in the case of Roths. When the traditional 401(k) owner makes withdrawals, that money (which has never been taxed) will be taxed as ordinary income. Roth account owners have already paid income tax on the money contributed to the plan and as long as they meet certain requirements, there will be no tax on their withdrawals.
Both traditional and Roth 401(k) owners must be at least 59½ — or meet other criteria set forth by the IRS, such as being completely and permanently disabled — when they begin making withdrawals.
Otherwise, they will typically face an additional 10% early-distribution penalty tax on top of any other taxes.
Some employers allow employees to take out loans against their contributions to a 401(k) plan. The employee is essentially borrowing from himself. If you take out a 401(k) loan, please consider that if you leave your job before the loan is paid off, you will have to pay it off in a lump sum or face a 10% penalty for early withdrawal.
required minimum distribution
Traditional 401(k) account holders are subject to required minimum distributions, or RMDs, once they reach a certain age. (Withdrawals are often referred to in IRS parlance as a “distribution.”)
After age 72, retiring account owners must withdraw at least a specified percentage from their 401(k) plans, based on their life expectancy at that time using IRS tables. (Prior to 2020, the age of RMDs was 70½ years.)
Note that distributions from a traditional 401(k) are taxable. There are no qualified withdrawals from Roth 401(k).
Roth IRAs, unlike Roth 401(k)s, are not subject to RMDs during the lifetime of the owner.
Traditional 401(k) vs Roth 401(k)
When 401(k) plans became available in 1978, companies…