This article was last updated on May 4
As more Americans shoulder the responsibility of funding their own retirement, many rely increasingly on their 401(k) retirement plans to provide the means to meet their investment goals. That’s because 401(k) plans offer a variety of attractive features that make investing for the future easy and potentially profitable.
Below we’ve listed a number of key points regarding 401(k) plans. Be sure to talk to your employer or plan administrator about the specific features and rules of your plan.
What Is a 401(k)?
A 401(k) plan is an employee-funded savings plan for retirement. It takes its name from the section of the Internal Revenue Code that created these plans, which are also known as “qualified defined contribution” retirement plans – “qualified” because they meet the tax law requirements for favorable tax treatment (described below) and “defined contribution” because contributions are defined under the terms of the plan, while benefits will vary depending on plan balances and investment returns.
The 401(k) plan allows you up to an IRS specified portion of your salary to a special account set up by your company. See current contribution limits, which are adjusted for inflation. Keep in mind that some employers may Institute lower limits on the amount you can contribute based on certain special status’. In addition, individuals age 50 and older who participate in a 401(k) plan can take advantage of “catch-up” contributions.
401(k) plans come in two varieties: Traditional and new Roth-style plans. A traditional 401(k) plan allows you to defer taxes on the portion of your salary contributed to the plan until the funds are withdrawn in retirement, at which point contributions and earnings are taxed as ordinary income. In addition, because the amount of your pretax contribution is deducted directly from your paycheck, your taxable income is reduced, which in turn lowers your tax burden.
The tax treatment of a Roth 401(k) plan is different. Under a Roth plan, contributions are made in after-tax dollars, so there is no immediate tax benefit. However, plan balances grow tax-free; you pay no taxes on qualified distributions. Both traditional and Roth plans require that distributions be qualified. In general, this means they must be taken after age 59 (or age 55 if you are separating from the employer whose plan will be making the distributions), although there are certain exceptions for hardship withdrawals, as defined by the IRS. If a distribution is not qualified, a 10% IRS penalty will apply in addition to ordinary income taxes on all pretax contributions and earnings.
Besides its favorable tax treatment, one of the biggest advantages of a 401(k) plan is that employers may match part or all of the contributions you make to your plan. Typically, an employer will match a portion of your contributions, for example, 50% of your first 6%. Under a Roth plan, matching contributions are maintained in a separate tax-deferred account, which, like a traditional 401(k) plan, is taxable when withdrawn.
Employer contributions may require a “vesting” period before you have full claim to the money and investment earnings. But keep in mind that if your company matches your contributions, it’s like getting extra money on top of your salary.
The Advantage of Tax Deferral
As you evaluate the potential benefits of a 401(k) plan, consider the advantage of tax deferral. When a hypothetical $100 monthly investment is made for 30 years in a traditional 401(k) plan, vs. a fully taxable investment account. Assume an annual 8% average rate of return compounded monthly and a 25% tax rate. For simplicity, it assumes the taxable account earns interest income only, which is taxed at the end of each calendar year.
The result? The entire amount in the 401(k) plan was withdrawn after 30 years and taxed, there would still be more money left than in the taxable account. Bear in mind that withdrawals from a 401(k) plan before age 59 may be subject to penalty taxes. This example is hypothetical and not indicative of future performance in your retirement plan.
The benefit of compounding reveals itself in a tax-advantaged account such as a 401(k) plan. As the accompanying chart shows, if your $100 monthly contribution accumulates tax-deferred over 30 years, you could grow your retirement nest egg to $150,030. That’s a difference of almost $50,000 just because you didn’t have to pay taxes up front! Of course, you’ll have to pay taxes on earnings and deductible contributions to a traditional 401(k) when you withdraw the money. But that will likely be when you are retired and may be in a lower tax bracket.
Generally, 401(k) plans provide you with several options in which to invest your contributions. Such options may include stocks for growth, bonds for income, or money market investments for protection of principal. This flexibility allows you to spread out your contributions, or diversify, among different types of investments, which can help keep your retirement portfolio from being overly susceptible to different events that could affect the markets.
When you change jobs or retire, you generally have four different options for what to do with your plan balance. You can keep the plan in your former employer’s plan, if permitted; you can transfer balances to your new employer’s plan; you can roll over the balance into an IRA; or you can take a cash distribution. The first three options generally entail no immediate tax consequences; however, taking a cash distribution will usually trigger 20% withholding, a 10% IRS penalty tax, and ordinary income tax on pretax contributions and earnings.
When deciding on which of the first three options to choose, you should consider available investment options and ease of access. Often, rolling over to an IRA provides the greatest flexibility and control, while affording a wide choice of investment alternatives.
Borrowing from Your Retirement Plan
One potential advantage of many 401(k) plans is that you can borrow as much as 50% of your vested account balance. In most cases, if you systematically pay back the loan with interest within five years, no penalties are assessed. If you leave the company, however, you may have to pay back the loan in full immediately, depending on your plan’s rules. In addition, loans not repaid to the plan within the stated period are considered withdrawals and will be taxed and penalized accordingly.
A 401(k) plan can become the cornerstone of your personal retirement savings program, providing the foundation for your future financial security. Consult with your plan administrator or financial adviser to help you determine how your employer’s 401(k) plan could help make your financial future more secure.