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 easier and potentially profitable. Be sure to speak to your employer or plan administrator about the specific features and rules of your plan.
What is a 401(k) plan?
A 401(k) plan is an employee-funded retirement savings plan. It takes its name from the section of the Internal Revenue Code that created these plans. 401(k) plans 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 tax treatment of 401(k) plans
The 401(k) plan allows savers to contribute up to $18,500 of salary in 2018 to a special account set up by their company.1 Future contribution limits will be adjusted for inflation. In addition, individuals aged 50 and older who participate in a 401(k) plan can take advantage of "catch up" contributions, which permit an additional $6,000 salary deferral contribution in 2018 in addition to the $18,500 limit discussed earlier.
Since 2006, 401(k) plans have come in two varieties: traditional and Roth-style plans. A traditional 401(k) plan allows savers to defer taxes on the portion of salary contributed to the plan until the funds are withdrawn in retirement or at age 59½, at which point contributions and earnings are taxed as ordinary income unless rolled over to another qualified plan or IRA. In addition, because the amount of pre-tax contribution is deducted directly from a paycheck, taxable income is reduced, which in turn lowers the saver's 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, earnings on plan balances grow tax free; no taxes are levied on qualified distributions.
Both traditional and Roth plans require that distributions be qualified. In general, this means they must be taken after 59½ (or age 55 for those who separate from service from the employer whose plan the distributions are withdrawn from), although there are exceptions for hardship withdrawals, as defined by the IRS. If a distribution is not qualified, a 10% penalty will apply in addition to ordinary income taxes on all pretax contributions and earnings.
If a plan permits, participants in the plan can make contributions in excess of the 2018 limit of $18,500 ($24,500 if over age 50), as long as the total contribution is not more than 100% of pretax salary, or $55,000, whichever is less. That means if a person's salary is $100,000, they can contribute up to $55,000 total to a 401(k) plan during that year. In the case of a traditional 401(k), however, only the first $18,500 ($24,500 if over 50) of contributions can be made pre-tax in 2018; contributions over and above that amount must be made after tax and do not reduce one's salary for tax purposes.
1The maximum salary deferral amount that you can contribute in 2018 to a 401(k) is the lesser of 100% of pay or $18,500. However, some 401(k) plans may limit your contributions to a lesser amount, and in such cases, IRS rules may limit the contribution for highly compensated employees.
In addition to 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 participants make to a plan. Typically, an employer will match a portion of employee contributions, for example, 50% of the 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 their investment earnings. But keep in mind that if your company matches your contributions, it's like getting extra money on top of your salary.
- Tax-deferred contributions and earnings on traditional plans.
- Tax-free withdrawals for qualified distributions from Roth-style plans.
- Choice among different asset classes and investment vehicles.
- Potential for employer-matching contributions.
- Ability to borrow from a plan under certain circumstances.
Tax-deferred compounding potential
The benefit of compounding reveals itself in a tax-deferred account such as a 401(k) plan. If a $100 monthly contribution accumulates tax free over 30 years, assuming a hypothetical 8% rate of return, a retirement nest egg could grow to $150,030. That's a difference of almost $50,000 just because current taxes did not need to be paid up front!2 Of course, taxes will be paid on earnings and elective deferral contributions to a traditional 401(k) when you withdraw the money. But that may be when in retirement and possibly in a lower tax bracket.
2 This example is hypothetical in nature and is not indicative of future performance, nor does it represent a specific product in your retirement plan. Withdrawals prior to age 59½ may be subject to a 10% penalty tax.
Choosing investments within a plan
Generally, 401(k) plans offer several options in which to invest contributions. Such options generally include mutual funds that may invest in stocks for growth, bonds for income, or money market investments for protection of principal. This flexibility may help lower investment risk by diversifying a portfolio amongst different types of classes, manager styles, investment styles, and economic sectors.
Provisions for changing jobs
Most 401(k) plans permit the employee who terminates employment the options of receiving the 401(k) balance in a lump sum (which is subject to tax) or to receive periodic payments (which are subject to tax) or to roll over the proceeds to an IRA or other employer-sponsored retirement plan. Additionally, some 401(k) plans permit the terminated employee to retain their 401(k) balance in their former employer's plan. Amounts that are retained in a former employer's 401(k) plan or transferred to another employer's plan or IRA postpone the taxation until amounts are subsequently distributed from the plan or IRA the money was rolled into.
When receiving funds from a 401(k) with the intention to roll the amount to an IRA:
- The rollover must be completed in 60 days.
- Employers must withhold 20% of the proceeds as a withholding tax. It is up to the participant to make up this 20%, or it will be treated as a distribution. The money withheld will be used as a credit against any income tax liability.
- Neither the 60-day rule nor the 20% withholding apply to amounts directly transferred to an IRA or other qualified plan.
Borrowing from a 401(k)
Another potential advantage of some 401(k) plans is the ability to borrow as much as 50% of vested account balance, up to $50,000. In most cases, if the loan is systematically paid back with interest within five years, there are no penalties assessed. However, borrowing from a 401(k) is generally not recommended since it reduces investable assets.
There are some other issues to consider. When leaving the company, the full loan amount may need to be repaid immediately (subject to the plan's loan policy). In addition, loans not repaid to the plan within the stated time-period are considered withdrawals and will be taxed and penalized accordingly.
Working with your financial and tax professionals
A 401(k) plan can become the cornerstone of a personal retirement savings program, providing the foundation for future financial security. Consult your financial and tax professionals to help you determine how your employer's 401(k) and other savings and investment plans could help make your financial future more secure.
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