Fundamentals of a 401(k) Retirement Plan

Fundamentals of a 401(k) Retirement Plan

How these egg pillars work, from first deposit to withdrawal

Since its inception in 1978, 401(k) plans have grown into the most popular employer-sponsored retirement plans in the United States. Millions of workers rely on the money they put into these plans to support their retirement, and many employers view 401(k) plans as a key benefit at work. Few other plans can match the relative flexibility of a 401(k) plan.

KEY TAKEAWAYS

  • A 401(k) is a qualified retirement plan, which means it qualifies for special tax benefits.
  • You can invest a portion of your salary, up to an annual limit.
  • Your employer may or may not match some of your contributions.
  • This money will be invested in your retirement, usually in various mutual funds of your choice.
  • You generally cannot withdraw any sum of money without a tax penalty until you are 59; 

What is a 401(k) plan?

A 401(k) plan is a retirement savings account that allows employees to divert a portion of their paycheck toward long-term investments. Employers can contest employees’ maximum contributions. 

A 401(k) is technically a “qualified” retirement plan, which means it qualifies for special tax benefits under IRS guidelines. There are two versions of the qualifying plan. They may be defined contributions or defined benefits, such as a pension plan. A 401(k) plan is a defined contribution plan. 

This means that the available balance in the account depends on contributions to the program and investment performance. Employees must contribute to this. Employers can choose whether to match a portion of that contribution. Investment gains in a traditional 401(k) plan are not taxed until the employee withdraws, usually; after retirement. After retirement, the account balance is entirely in the hands of the employee. 

More than 100 million Americans enjoy a defined-contribution plan, such as a 401(k) or similar, and nearly half of all U.S. private-sector employees enjoy a defined-contribution plan. According to a 2019 report by Vanguard, nearly half of these plans are immediately awarded to participants with employer matching contributions. 

Roth 401(k) Variations

While not all employers offer this service, Roth 401(k) s are an increasingly popular option. This version of the plan requires employees to pay income tax on their contributions immediately. After retirement, however, the money can be withdrawn without having to pay taxes on contributions or investment gains. 

Employer contributions can only go into a traditional 401(k) account, not a Roth account. 

401(k) Contribution Limits

This maximum wage employee can comply with a 401(k) plan, either a traditional or a Roth plan, for $19,500 in 2021 (same as 2020). Employees aged 50 and older can have an additional catch-up contribution of up to $6,500 in 2021 (the same as in 2020). 

In 2021, employers and employees can jointly contribute up to $58,000 (up from $57,000 in 2020), and those 50 and older can contribute up to $64,500 (up from $63,500 in 2020). 

Restrictions for high earners

For most people, the contribution limit is in a 401(k) plan, and the interest rate is high enough to allow an appropriate level of income deferral. In 2021, high-paid employees will only be able to use the first $290,000 of earnings when calculating the highest possible contribution. 

Employers may also offer ineligible programs, such as deferred compensation or executive bonus programs for these employees.

401(k) investment options

Companies that offer 401(k) plans often offer employees a variety of investment options. Options are typically managed by a financial services advisory group such as the Vanguard Group or Fidelity Investments.

Employees can choose one or more funds to invest in. Most options are mutual funds, which may include index funds, large-cap and small-cap funds, foreign funds, real estate funds, and bond funds. They typically include aggressive growth funds and conservative income funds.

Withdrawal rules

Distribution rules for 401(k) plans differ from those that apply to individual retirement accounts (IRAs). In either case, early withdrawal of assets from either plan means paying income tax and, with a few exceptions, a 10% penalty for those under the age of 59; 

However, while no reason is required for an IRA withdrawal, the triggering event must be content to accept a 401(k) plan payment. 

The following are common trigger events:

  • Employee retires or leaves.
  • Employee death or disability.
  • Employees aged 59 & 12.
  • The employee experienced a specific hardship as specified in the plan.
  • Program terminated. 

post-retirement rules

The IRS authorizes the 401(k) account owner to start what it calls the required minimum distribution unless the employer still employs the person. This is different from other types of retirement accounts. For example, you must withdraw RMDs from a traditional IRA even if you are employed. 

Money withdrawn from a 401(k) plan is generally taxed as ordinary income.

In December 2019, the Establishment of Retirement Benefits & (Security) Act for Every Community raised the age for RMDs from 70 to 72. 

Rollover option

Many retirees transfer their 401(k) plan balances to traditional IRAs or IRA Roth IRAs. This tipping allows them to move away from the limited investment options that often appear in 401(k) accounts. 

If you decide to roll, do it right. In a direct rollover, the money is transferred directly from the old account to the new account with no tax implications. In an indirect rollover, the funds are sent to you first, and you owe the full income tax on the balance for that tax year. 

If you have employer stock in your 401(k) plan, you are eligible to take advantage of the Unrealized Net Gain (NUA) rule and receive capital gains processing that will significantly reduce your tax bill. 

To avoid penalties and taxes, rollovers must be made within 60 days of withdrawal of funds from the original account. 

401(k) Program Loans

If your employer allows it, you can get a loan from a 401(k) plan. If this option is allowed, up to 50% of the vested interest balance can be borrowed, up to a limit of $50,000. The borrower must repay the loan within five years. A single home purchase allows for a longer repayment period.

The CARES Act doubles 401(k) loan amounts to $100,000 in 2020, but only if you’ve been impacted by the COVID-19 pandemic and your plan allows the loan. 

In most cases, the interest paid will be lower than the cost of paying the actual interest on a loan; bank; or consumer loan, which you will pay yourself. Please note, however, that any unpaid balance will be considered a distribution and taxed and penalized accordingly. 

By aamritri

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