What Is a 401(k)?
401(k) is an investment plan by which you can save and invest for retirement. A participant can make contributions from their paycheck either before or after tax. This can completely depend on the options offered in the plan. Sometimes, your employer may also deposit money into your account that matches your contributions up to a certain percentage.
There are two main types of retirement plans: A defined benefit plan and a defined contribution plan. When it comes to defined benefit plans, also known as traditional pension plans, the employer promises a specified monthly benefit at retirement. These benefits are based on the employee’s salary, age, and the number of years worked. Traditional pension plans provide employees with the exact amount promised and are calculated by factors such as salary and service.
On the other hand, a defined contribution plan is also a retirement plan in which the employee or employer and sometimes both contribute to the employee’s account under the plan. For these plans, the value of the account changes based on the contribution levels and performance of the investments. So, you cannot determine how much a defined contribution plan will give an employee on retiring. 401 (k) plans, 403 (b) plans, employee stock ownership plans, and profit-sharing plans are examples of these plans.
The Two Types of 401(k) Plans
The 401(k) plan can be typically divided into two: Traditional and Roth. The primary difference between them is how they are taxed.
- Traditional 401(k)s
The contributions to the traditional 401(k) plan are made from an employee’s gross income. That is, the money will be taken directly from your paycheck before taxes are deducted. This lowers your taxable income for the year. Taxes must not be paid until you finally withdraw the money on retirement.
The withdrawal is considered as a regular income, and thus, tax must be paid. Since these contributions are particularly meant for retirement purposes, you cannot withdraw them before the age of 59 ½. However, if there is an emergency and you are in need of it, you can have it, but only after paying tax penalties. Anyway, there are some exceptions to that rule.
You have to follow the required minimum distribution (RMD) rules while withdrawing funds from a traditional 401(k) plan. An RMD is a sum that should be withdrawn annually from retirement plans. Account owners can calculate their RMDs based on the tables and worksheets provided by the IRS Publication 590-B.
- Roth 401(k)
The Roth 401(k) emerged in the early 2006. Until then, the only option available was traditional 401(k). Roth 401(k) is named after former U.S. Senator William Roth of Delaware, who was the primary sponsor of the 1997 legislation which made the Roth IRA possible. Although it was not accepted at first, many employers use it widely now.
The Roth 401(k), also known as a designated Roth account, is much like a traditional 401(k). The only difference between them is that Roth 401(k) receives contributions after tax deductions. However, the withdrawals would be tax-free if the employee has met certain demands. Roth 401(k) is particularly beneficial for employees if they have many years until retirement since all the money will be tax-free upon withdrawal.
If your employer offers both of these plans, you can split your contribution and add them to both. While doing so, it would always be better to speak with a professional or a financial advisor.
How Does a 401(k) Account Work?
Contribution:
As per the United States Census Bureau 2021 Survey of Income and Program Participation, the most common retirement accounts in 2020 were 401(k) accounts, approximately 34.6%. When a worker signs up for a 401(k) account, they will have to deposit a portion of their paycheck directly into the investment account.
- If you are investing in a Traditional 401(k) account, the amount is deducted before taxes are applied. For instance, if your salary is $5000 a month and you are contributing 10% of the salary – $500 will go into your 401(k) account. You will be only taxed from the remaining $4500. By depositing into a Traditional 401(k) account, you can reduce the taxable income for the year. However, when you withdraw money during retirement, these withdrawals will be taxed as ordinary income.
- If you are investing in a Roth 401(k) account, the amount is deducted after taxes are applied. So, the amount you contribute to the Roth account is already taxed. Therefore, the Roth 401(k) account withdrawals are tax-free in retirement.
Employer Matching Contributions:
Some employers offer a matching contribution. This means they will contribute a certain percentage of money into your 401(k) account to match the contributions you make. Depending on your 401(k) plan’s terms, an employer may choose dollar-for-dollar, partial, or sometimes non-matching contributions.
- Dollar-for-Dollar 401(k) Match: An employer matches 100% of an employee’s contribution in this dollar-for-dollar 401(k) match. For example, if you contribute 3% of your income to 401(k) annually, the employer offering dollar-for-dollar will match up to 3% of your salary.
- Partial 401(k) Match: An employer’s contribution will be a portion of an employee’s contribution. For example, if you contribute 6% of your salary, the employer will contribute maybe 50% of that 6%. This means they will contribute 3% in total.
- Non-matching 401(k): This is also referred to as a profit-sharing contribution. These contributions are made by the employer regardless of whether the employee makes any contributions to their 401(k). For non-matching contributions, companies usually look into their annual profit or revenue growth.
Vesting:
Vesting is the process by which you earn full ownership of your employee’s contributions to your 401(k) plan. In vesting, the employer contributions belong to the employee immediately, but the employee’s contribution belongs to the employee only after a vesting period. The principal purpose of vesting in a 401(k) plan is to provide an incentive for employees to stay with the company for a certain amount of time. Many companies’ policies need employees to be fully vested. If you leave the company before you are fully vested, you may lose a portion or all of the employer-contributed funds.
There are mainly three types of vesting schedules –
- Immediate Vesting: This can apply to employee contributions, employer contributions, or both. In immediate vesting, when all employer contributions become 100% vested as soon as they are available to the employee. Even if you leave the company, you can still own all the money you contributed to the 401(k) plan.
- Graded Vesting: You can contribute in different percentages depending on how long you have been with the company.
- Cliff Vesting: In this schedule, you will not own any of the employer contributions until you have reached a certain period.
How to Make an Early Withdraw from Your 401(k)
It is possible to withdraw money from your 401(k) even if you are under 59½. However, in this situation, you will have to pay a penalty of 10% and an income tax bill. This method is not at all advisable as it depletes retirement savings permanently.
You can avoid the penalty if you are qualified for a hardship withdrawal under the Internal Revenue Service (IRS). The IRS permits you to withdraw money without a penalty for ‘immediate and heavy financial needs.’ Here, the employer determines whether the participants’ need comes under this category. Needs such as buying a television or a boat can never be considered an immediate and heavy financial need. So, you cannot withdraw money from your 401(k) plan without a penalty for these silly reasons.
You can withdraw money with no penalty for paying qualified educational expenses, unreimbursed medical bills, etc. Also, you are allowed to withdraw up to $5000 without penalty if you need to pay expenses that are related to the birth or adoption of a child, according to the terms of the SECURE Act of 2019.
Withdrawal Alternatives
- Loan: Instead of withdrawing money with penalty you can take a loan from the plan. Actually, in this process, you are taking a loan from yourself with a commitment to pay it back. You can either borrow $50,000 or 50% of your account balance, whichever is less.
- SEPP withdrawals: These are ideal if you need to access your retirement savings early due to unemployment or other financial needs. It helps you to avoid the 10% early withdrawal penalty. They provide a steady income for you even before your retirement. However, this can reduce the amount available after retirement. The IRS offers three methods for calculating your distributions from a SEPP: Amortization, Annuitization, and Required minimum distribution.
Annual Contribution Limits
- The maximum amount an employee could contribute until 2023 was $22,500. In the year 2024, this amount has been raised to $23,000. Additionally, the catch-up contributions for those 50 or older is $7,500.
- The joint contribution of the employer and employee has been raised from $66,000 to $69,000, and the total with catch-up contributions for those 50 or older has been raised from $73,500 to $76,500.
Advanced 401(k) Investment Strategies
- Target-Date Fund: This is a type of mutual fund that automatically adjusts the asset allocation over time based on your estimated retirement date. It invests more aggressively during the initial time and shifts to a more conservative allocation when the target date is near.
- Managed Accounts: These are accounts managed by professionals for a fee. Although these offer you customized investment strategies, the higher fees may turn against you. So, before using these accounts, it’s crucial to compare the costs with the potential benefits.
- In-Service Withdrawals: Certain plans may offer in-service withdrawals. This means that you can transfer funds to an IRA while you are still employed. Although this opens up more investment options, it comes with certain restrictions and penalties.
To conclude, 401(k) is one of the most adopted retirement plans available today. The two major types of 401(k) plans, Traditional and Roth, are significantly important for employees to have a regular income even after retirement. Plans like these help people to secure their lives even in old age. The ability of the 401(k) plan to offer employer-matching contributions and tax-free growth provides participants with a structured way to save for retirement. Understanding more about how a 401(k) plan helps you invest money for the future effectively.