The 401(k) is a frequently mentioned and widely-used retirement vehicle by companies. Its main purpose is for employers to help their employees achieve their retirement goals. But how does it work? How do you sign up for one? What happens to your 401(k) when you quit a job?
In this article, we discuss relevant topics on the 401(k) plan, including how to open one, how to use one and why it can be one of, if not your best investment for helping you with your retirement goals.
To financial planners and wealth advisors: use this article as a client education piece to introduce the benefits of 401(k) plans to your contacts.
The 401(k) plan is a type of retirement savings account that is tax-deferred. It’s one of the most offered retirement plans offered by US employers.
It’s called 401(k) after the subsection of the IRS code it’s classified under, section 401(k). The plan was originally introduced by US Congress after thorough deliberations on retirement plans in 1974. The 401(k) plan was made to encourage Americans to save money for their retirement.
On another interesting note, Internal Revenue Code 401(k) was first implemented in 1978 but didn't gain popularity until the 1980s. One of the first to establish a 401(k) plan was Ted Benna, who designed it for his own employer, Johnson Kendall & Johnson (formerly known as the Johnson Companies).
At that time, JKJ employees contributed 25% of their salary with a limit of $300,000 per year to their employer’s 401(k).
This works as a company-sponsored retirement plan offered by US employers. The employee who signs up for a 401(k) plan agrees to have a portion of their salary (usually a percentage) paid straight to an investment account.
The employer then has the option to match the contribution partially or fully and invest these matching contributions on their employee’s behalf, such as in high-performing mutual funds, for example.
It's the employee who gets to choose from a few investment options made available to them, often in the form of mutual funds. Depending on the type of the 401(k) plan, the taxes can be deferred until the employee withdraws them upon retirement.
There are only two main types of 401(k) plans, each having their own set of tax benefits.
In a traditional 401(k), the employee’s contributions are sourced from gross income. This means that the money is taken from your paycheck before deducting income tax.
As a result, this type of 401(k) reduces the taxable income by the total amount of contributions for the year, which can be used as a tax deduction for that tax year. The money contributed or the investment earnings aren’t taxed until you withdraw the money, usually upon your retirement.
In a Roth 401(k), contributions are taken from after-tax money. What this means is that contributions are taken from your paycheck only after deducting income taxes. In this setup, there is no tax deduction during the year of the contribution. However, the advantage of this is that you don’t have to pay any additional taxes on the earnings or your contributions.
As with the Roth IRA, there are taxes levied on withdrawals made on the Roth 401(k) before the account holder reaches the age of 59½. It’s best to check with an accountant or financial advisor before withdrawing any money from either of these plans.
Remember also that not all employers may offer you the option of a Roth 401(k). But if your employer does offer you that option, this usually means both types of 401(k) plans are available. You can contribute to both types of plans as long as you don’t go over the annual contribution limit.
Making contributions to a 401(k) plan gives a host of benefits, including:
The primary tax benefit of a 401(k) comes from the fact that contributions are on a pre-tax basis. That means you can deduct your contributions in the year you make them, and your taxable income for that year is lowered. This applies only to traditional 401(k) plans, and not Roth 401(k) plans.
Another tax benefit for 401(k) plans is that their earnings are on a tax-deferred basis. That means the dividends and capital gains that grow inside your 401(k) are likewise tax-free until you make withdrawals.
These tax benefits can be significant if you find yourself in a lower tax bracket upon retirement—which is also when you take money out—as opposed to when you are employed and still making contributions. This is especially true for investors who are still in a high tax bracket and receive an immediate tax benefit from the deduction of their contribution.
In some cases, employers may offer to partially or even fully match the contribution amounts to your 401(k) plan. There are even employers who add a profit-sharing scheme that adds a percentage of the company’s profits to their employee’s 401(k).
Should your employer offer one or both perks, it’s wise to sign up for them. These features are practically free money added to your retirement plan at little risk to you.
There are a lot of different types of 401(k) matches a company can offer. Here are some examples:
Compared to an IRA, much more can be saved each year with a 401(k). For 2023, the 401(k) contribution limit is $22,500, and individuals 50 years old or older can make an additional catch-up contribution. For 2023, the catch-up contribution limit was an additional $7,500.
There are also limits to the total amount you and your employer can contribute to your 401(k). In 2023, the annual addition paid into a 401(k) participant's account cannot exceed 100% of the participant's compensation or $66,000 (whichever of the two is lower).
The thresholds listed above increase to $73,500 in 2023 and $67,500 for individuals 50 years or older that are eligible for catch-up contributions.
Until 2019, individuals who reached the age of 70½ could no longer contribute to traditional and Roth IRAs. But as of 2020, the IRS has removed the age limits on making regular contributions to traditional or Roth IRAs.
This good news now also applies to 401(k)s. You may continue to contribute to your 401(k) for as long as you are able to work or choose to do so. What's more, you don’t have to take any mandatory distributions from the plan, for as long as you own less than 5% of the business that employs you.
As the 401(k) plan was created under the Employee Retirement Income Security Act (ERISA), it cannot be accessed or taken by creditors. Note even a court ruling can enable creditors to take possession of what's in their debtor’s 401(k) to satisfy final judgment or their contractual obligations.
The protection against creditors in a 401(k) is potent enough to resist any claims on a taxpayer’s assets with outstanding back taxes. That's because legally, the 401(k) plan belongs to your employer. Depending on the provisions of the plan, your plan’s administrators may be able to refuse even the IRS to place a federal lien on it.
The easiest way to enroll in a 401(k) is signing up through your employer. Many US companies offer this plan, with some even willing to match a portion of their employees’ contributions.
Some employers offer above-average plans as a recruitment tool. When you sign up via your employer, your paperwork and payments will usually be handled by the company as you are onboarded.
Even if you’re self-employed, you can still have a 401(k) plan, known as a solo 401(k) or independent 401(k). These types of plans also provide freelance workers and independent contractors with a retirement fund, even if they don’t have an employer to sponsor them. Solo 401(k)s can be set up with an online broker.
The 401(k) has become the preferred retirement plan for many US employers and employees. To date, about 31% of employees in the US have a 401(k), which is about 60 million people.
This video describes in more detail how this retirement plan practically left pensions in the dust:
If you had to leave a job for whatever reason before retirement, there are a few options you have regarding your 401(k). You can:
To maximize the benefits and savings of your 401(k), you’d be wise to avoid these common mistakes that many people can commit with their 401(k) plans:
When an emergency arises, it’s not advisable to dip into your retirement savings. Doing this can make your plan miss out on rare growth opportunities, potentially costing you thousands of dollars in earnings.
A better strategy is to set up a separate emergency fund, perhaps even well before you start on your 401(k). Doing this will keep your retirement earnings and savings in your 401(k) intact and allow it to grow undisturbed.
Taking money out of your 401(k) before you reach retirement or age 59½ means taxes and penalties. Early and unnecessary withdrawals can also mean your 401(k) loses out on compounding interest.
Avoid making any withdrawals before retirement, and also try to avoid cashing out a 401(k) from your former employer. It’s better to leave it untouched or consolidate it with the 401(k) at your new employer.
Some investors in a 401(k) account make the mistake of taking an aggressive approach and attempt to “beat the market” to get bigger growth gains. With a 401(k) plan, time is your greatest ally.
Taking on an aggressive strategy with high-risk assets might seem like a good idea for max growth. But if you’re like most 401(k) account holders and aren’t a market expert, it's better to not take chances.
Remember that even the best experts aren’t miracle workers – they too can make mistakes and can be wrong about “timing the market”.
Adopt a conservative approach, especially when it involves investments that can be crucial to your retirement. Do not try to make any major 401(k) buying or selling decisions without the help of a trusted professional.
Once you’ve set up your 401(k) to automatically take contributions from your pay, look into the maximum employer match you can get. Also, find out how much you must save in your 401(k) to be eligible for the match.
Be sure to check that the employer match you’re enrolled in is what you’re entitled to receive. Even a small difference of $10 a week in contributions can make a huge impact when you’ve reached retirement age.
Lastly, if your employer’s 401(k) plan provides access to guaranteed income solutions like annuities, be sure to sign up for them too. With these added, the plan itself can significantly cut down the institutional fees.
As of December 29, 2022, the SECURE 2.0 Act was passed. This new law introduced significant changes to 401(k) plans of small businesses. This included provisions for expanded coverage, increased retirement savings, and revised retirement plan rules for clarity and simplicity.
The premise of the 401(k) plan is to encourage Americans to save for their eventual retirement. With its tax benefits, shelter against creditors, and employer contribution match, this is a secure vehicle for anyone who wants to build a retirement nest egg. Along with the recent additions for small businesses, the 401(k) remains to be the best investment for securing a decent retirement.
As a retirement vehicle, does the 401(k) appeal to you? Which of them will you use, a Roth or traditional 401(k)? Let us know in the comments!
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