Your complete guide to understanding how a 401k plan works.
Are you looking to build up a nest egg to sustain the retirement lifestyle you desire? Or want to be part of an employer-sponsored plan that allows you to divert a portion of your salary in retirement savings?
If your answer is “Yes” to the questions above, then a 401k plan might be the best fit for you.
This article provides a complete overview of the different features of a 401k plan and how it can help you save right off the bat by reducing your taxable income.
What Is a 401K Plan?
A 401k plan is a retirement savings account offered by American employers. Employees are able to dedicate a portion of their pre-tax salary to an investment account. The two basic types of 401k’s differ in terms of how they’re taxed. In a traditional 401k, money is deducted from the gross income, and no taxes are payable until the money is withdrawn. Whereas in a Roth 401k, employees are required to pay the income taxes upfront but can make tax-free withdrawals. The funds are invested in a range of saving vehicles like mutual funds, stocks, cash, and so forth. The 401k plan has been named after the subsection 401k of the US internal revenue code.
Both the employer and the employee can make contributions to the account up to the limits stipulated by the internal revenue service. A 401k is also identified as a defined contribution plan whereby employees are responsible for selecting their choice of investments. Unlike a traditional pension that is becoming more rare, a 401k plan allows employers to shift the responsibility and risk of saving for retirement to their employees. The maximum amount of salary that an employee can divert to a 401k plan is adjusted to account for inflation on a periodical basis. As of 2021, the amounts are $19,500 per year for workers under 50 and $26,000 for those over 50. The latter are also allowed to make catch-up contributions of up to $6500.
How Does a 401k Plan Work?
A 401k plan offers substantial tax advantages. The employer is responsible for running the plan in accordance with the rules and regulations, which include deciding who is eligible for the plan, how much both the employer and employee can contribute, and the investment options available.
So If you want to participate in a 401k plan, you will be responsible for deciding how much you want to contribute to the savings account. If, for example, you elect to defer 5% of your pay, then the required amount would be deducted from your salary and placed in a 401k plan. By contributing to a 401k plan, you actually have the opportunity to lower your taxable income as the amount would be deducted from your gross income. You won’t be liable to pay taxes on the money you have contributed unless you decide to withdraw the funds from your account.
There are two types of a 401k plan, each that come with its own tax benefits:
1. Traditional 401k
A traditional 401k will deduct an employee’s contribution from their gross income. This will reduce the employees’ taxable income, and no taxes will be due on the money contributed unless they withdraw it from the account. Employees will be required to owe taxes on both their investment earnings and original contributions. A traditional 401k owner must meet the requirements spelled out in the IRS.
Moreover, it might also be the best option for those employees who expect to be in the lower marginal tax bracket upon retiring.
Many employers also allow their employees to take out a loan from their 401k contributions. However, if an employee decides to leave the job before the money is repaid, they must pay it in a lump sum or face a 10% early withdrawal fee.
Traditional 401k owners have to follow the required minimum distributions or RMDs after reaching a specified age. A required minimum distribution is the amount of money that must be withdrawn from a retirement account. After reaching a certain age, retired account owners are expected to withdraw a percentage from their 401k accounts using IRS tables based on their life expectancy.
2. Roth 401k
A Roth 401k deducts an employee’s contributions from their after-tax income. Thus, the employee will be required to pay taxes on that money immediately. No additional will be due on the employee’s original contributions and investment earnings when the money is withdrawn during the retirement period. Many employers offer a mix of both types of 401k plans. However, their contributions to both accounts cannot exceed the limits set for one account, typically around $19,500 for those under 50.
Roth 401k plans are becoming an increasingly popular option among employers. Employees who expect to be in the higher marginal tax bracket might want to go for a Roth 401k so that they’re able to avoid taxes on their savings and investment earnings during their retirement.
While Roth reduces an employee’s immediate spending power, it might pay off in the long term. Saving money that has been deducted from taxes can earn you substantial wealth in your retirement years. All the investment earnings that would be generated will be tax-free. An employee can withdraw their earnings without incurring a tax or a penalty. Only if they are at least 59 years old and it has been five years since they have contributed to the account regardless of your age at the time. However, if someone was 58 years old when they made their first contribution, they’ll still have to wait till the age of 63 to avoid taxes.
Furthermore, let’s suppose an employee has no intention of retiring at an early age and wants to keep their money in a 401k for other purposes. A Roth 401k offers a substantial advantage in estate planning as potential heirs will be able to benefit from the tax-free money as the original owners would have. If one does happen to retire, they can easily make their heirs the beneficiaries of the accounts without having to incur any taxes. Although they will have to start withdrawing money from the Roth 401k, the money won’t be taxed.
How Much Do Employers Contribute to a 401k Plan?
Employers can contribute to your 401k in different ways:
1. Matching Contributions
If your employer offers a matching contribution, they will only put money into the plan if you choose to do so. They will be putting the same amount that you contribute to your 401k plan. For example, they might match your contributions for a dollar for a dollar up to 3% of your pay or 50 cents for a dollar on your next pay.
Your employer could add $2500 if you elect to defer 5% of your $50,000 salary. They would first match the 3% of your pay and match 50 cents on the dollar for the next 2% of your payment. You will still be allowed to contribute more than 5% of your salary, but your employer will only offer that amount in the contributions.
2. Non-elective Contributions
Your employer may choose to contribute a fixed percentage into the account of all workers. Hence, if your employer decides to contribute 3% of your $50,000 salary, you will receive a fixed annual contribution of $1500 to your account.
3. Profit-sharing Contributions
The company may choose to contribute to a 401k plan if it makes a profit. They will use different formulas and calculations to make a contribution that’s proportional to your pay.
What Happens to Your 401k If You Leave Your Job?
If you leave your company where you have a 401k plan, you’ll have several options to choose from. These include:
1. Withdrawing Your Money
Generally considered as a bad option, your original contribution will be taxable in the year its withdrawn. If you’re under 59 and a half years, you might incur a 10% early withdrawal fee. In addition, if you are the owner of a traditional 401k plan, then you will also be required to pay income taxes upon withdrawing your money from the account.
However, the rule has been suspended due to the onset of the global coronavirus pandemic. In the case of a Roth 401k, your investment earnings and original contributions can be withdrawn tax-free as long as you’ve held the account for at least five years.
2. Rolling your 401k savings in an IRA (Individual Retirement Account)
Another option for you is to divert your balance in an IRA at a brokerage firm or a bank to avoid immediate taxes. Rather than withdrawing the savings and depositing them in an IRA, it is advisable to initiate a trustee to trustee transfer.
Many banks allow you to open a new account as a rollover IRA so that you don’t have to worry about incurring withdrawal taxes and contribution limits. Make sure you roll your traditional 401k contributions in a traditional IRA and your Roth 401k contributions in a Roth IRA. It’s also vital that you choose the direct rollover method so that your employer can directly issue the check to the company that’ll be managing your IRA. Your employer may need to withhold taxes on your 401k if you accept a check in your name.
3. Leaving your 401k with your old employer
Many employers allow you to keep a 401k on an indefinite basis. However, you would need to have an account that’s worth at least $5000. Otherwise, you may have no other choice but move your savings elsewhere. In contrast, some employers may require you to roll over your 401k balance within a set period of time after you’ve left your job.
It will only make sense to leave your 401k money with your old employer only if you’re satisfied with the selection of investment choices the plan has to offer. The downside may be that you will need to keep track of all the 401k accounts over the course of your career.
4. Moving your 401k to a new employer
You may be allowed to move your 401k balance under your new employer’s plan. That way, you’ll be able to maintain the account’s tax-advantaged status and avoid immediate penalties. It may turn out to be a favorable decision if you aren’t comfortable in managing a rollover IRA. Make sure to check with your respective employers on whether they accept a trustee to trustee fund transfer.
In addition, if you’re over 71 years, then the money in your 401k under your new employer’s plan might not be subject to requirement minimum distributions.
How Much Should You Be Putting in Your 401k Plan?
You might want to know how much money you should ideally set aside in retirement savings. For that, it’s important to be aware of the contribution limitations for employees who participate in a 401k plan. The elective deferral contribution amount, as of 2020 and 2021, is $19,500, up from $19,000 in 2019. There’s also an additional catch-up contribution for employees aged 50 who can contribute an additional $6,500 to the account.
A common rule of thumb is to sock away at least 10% of your gross earnings as a start. According to Arvie Korving, a financial advisor with Koving & Company in Suffolk, there isn’t any ideal contribution to a 401k plan unless the company offers a matching contribution. Many plans may require you to defer 6% of your income in order to get a full match.
If you are well into your 50s, you might need to increase your contribution amount, considering that you will likely be in your peak earning years. So if you’re turning 50 soon, you can contribute an additional $6500 over the contribution limit of $19,500. An ideal retirement contribution may depend on various factors, but as Nickolas R.Strain suggests, one should move closer to a 20% contribution to the retirement plan and stick to it as the salary increases.
Financial advisor with Halbert Hargrove in Long Beach, Nickolas adds: “Most financial planning studies suggest that the ideal contribution percentage to save for retirement is between 15% and 20% of gross income. These contributions could be made into a 401(k) plan, 401(k) match received from an employer, IRA, Roth IRA, and/or taxable accounts. As your income grows, it is important to continue to save 15% to 20% of it so that you can invest the funds and grow your investments until you need to start taking distributions in retirement.”
Another way of determining how much you need to save will depend on what income amount you’ll need to save up for retirement. Luckily, there are plenty of online calculators out there to help you figure out the amount you should be aiming for. These include:
- Nerd wallet helps you figure out your saving target and incorporate different contributions and matching amounts within the calculation.
- CalcXL that offers recommendations on how much you should be ideally saving by accounting for projected inflation
How to Make Your 401k Investments?
Many investment options are offered under a 401k plan. Investing in a 401k can be risky, and in some cases, returns may never be guaranteed. Hence, you’ll have to determine an appropriate allocation on how much your investments will be in stocks, bonds, and so forth. Once you start participating in a 401k plan, you will have to choose from a range of investments.
Mutual funds are the most common investment options that are offered in a 401k plan, while exchange-traded funds (ETF) are also being offered now. You can potentially invest in thousands of funds, but your company’s 401k plan will only offer a small range of investment options ranging from conservative to more aggressive funds.
A conservative fund sticks to high-quality bonds that are generally regarded as safe investments. Your money will grow slowly yet predictably, and you would rarely lose the funds you put in. On the other hand, investing in an aggressive growth fund might mean that your funds may experience big gains or huge losses.
Since the past few years, mutual funds and ETF expense ratios have been on a downward trajectory, a win for investors. It’s important to pay attention to the expense ratios-amount you’re charged for investing in a certain fund-which should be below 1%. According to Warrant Buffet, the owner of Berkshire Hathaway with over 360,000 employees, says that costs are an essential component in investment. In 2017, he told CNBC the following: “If returns are going to be seven or 8% and you’re paying 1% for fees, that makes an enormous difference in how much money you’re going to have in retirement.”
On the other hand, if you opt for index funds, you should pay no more than 0.25% in annual fees. They are considered to have the lowest fees as they require little management by a professional. Hence, it’s always in your best interest to avoid funds that charge a high management or sales fee.
Alternatively, you can also opt for a target-date fund whereby you select a target retirement year and risk tolerance. The fund is then automatically diverted to the most appropriate asset allocation for you. Over time, your fund will rebalance and become more conservative as you approach retirement. Choosing a target-date fund means choosing only one fund; otherwise, you will be essentially canceling out its benefits that are expected to accrue from the investment.
According to many financial experts, it’s always beneficial to build your contributions each time you get a raise or a bonus. Consistently investing a portion of your paycheck every time can make a sizable difference in your earnings.
Lastly, no matter how many funds you have been offered, you will still be required to do a bit of research in order to make your selections. One way of doing so is to search the name of the fund on the “Morningstar” website, where you’ll be directed to the fund’s profile page that lists down its features. Additionally, you can also search its name on google to get an idea about the best performing funds from last year.
Overall, 401k plans are an excellent way for employees to build their retirement savings over time. Not only does it offer a range of investment options, but allows you to reduce your taxable income depending on the type of account you may opt for. Some employers may also match your contributions-allowing you to maximize your savings.
It is important to check with your respective employers to find out more about the 401k plans they are offering. Determining your risk tolerance and how much you can contribute are also a few factors to consider while picking the right investment that can set the tone for your retirement.
If you go by the “Pay Yourself First” mentality, then the 401k plan might be the best fit for you. You will be achieving your goal of making sure that you have enough income saved while also removing your temptation to skip a contribution and spend it on unnecessary expenses. Thus, it is in your best interest to weigh all your options and identify ways that allow you to take full advantage of such a plan.
You can visit the Retirement Plans FAQ page of the US Department of Labour Website to learn more about the rules a 401k plan must follow.