- A 401(k) is a defined contribution plan, which means that plan participants voluntarily contribute a percentage of their earnings to a personal retirement savings account.
- A 401(k) is not an investment, but an account money is invested from. Plan participants select from a list of investments available through their employers.
- Withdrawals from traditional 401(k)s are taxed as ordinary income. Roth 401(k) distributions are not taxed if a participant is at least age 59 ½ and the account is open for at least five years.
401(k) Plan Overview
Now that relatively few workers have pensions, employer retirement savings plans are an important source of income in later life. There are different plans for different types of employers. 401(k) accounts, designated after a tax code section, are accessible to employees of for-profit enterprises extending these retirement options.
A 401(k) functions as a defined contribution strategy, where participants willingly set aside a portion of their earnings into an individual retirement savings account, staying within the annual limits set by the IRS.
For example, if you earn $50,000 annually and contribute 5% of your income, savings for the year would be $2,500 divided among the number of paychecks you receive.
By leveraging traditional 401(k) contributions, individuals can lower their federal income tax burden, as these contributions are deducted from taxable earnings. State tax implications may differ. Notably, both contributions and earnings remain untaxed until withdrawals are made. Many employers also match their employees’ contributions.
401(k) Contribution Limit
In 2023, the 401(k) contribution ceiling stands at $22,500, increasing to $30,000 for individuals aged 50 and above, featuring an additional catch-up limit capped at $7,500. It’s important to note that these maximum contribution limits undergo annual indexing to account for inflation.
Read More: Average 401(k) Balance by Age
While not inherently an investment, a 401(k) functions as an account where plan participants choose investments provided by sponsoring employers. Employers, generally through plan providers, curate a list of investment choices for participants to choose from. Choices will often include mutual funds and exchange traded funds (ETFs), such as stocks and bonds.
It is also possible to rollover 401(k) funds into another qualifying account, such as a traditional IRA, for a broader selection of investments, or an annuity, for a guaranteed stream of lifetime income. With a direct rollover, investment earnings continue to grow tax-deferred.
Mapping Out Your Retirement: Are You on Track?
Types of 401(k) Plans
A comparison chart from the Internal Revenue Service (IRS) describes differences in plan contributions, income limits and distributions. Employers generally offer two categories of 401(k) plans for their employees: traditional and Roth.
Traditional 401(k) Plans
Traditional 401(k) plans allow employees to contribute pre-tax dollars that are invested according to their selected asset allocation. There is no income limit for traditional 401(k) contributions, but there is a maximum IRS aggregate defined contribution plan limit ($66,000 in 2023).
Withdrawals from traditional 401(k) plans are typically taxed as ordinary income. However, there’s a notable exception known as the “still working exception” applicable to older employees who remain with their current employer’s 401(k) plan past the age when Required Minimum Distributions (RMDs) would ordinarily begin. Under this exception, RMDs from the employer’s plan can be deferred until April 1 following the year in which the individual retires.
Roth 401(k) Plans
Roth 401(k) plans, also referred to as designated Roth accounts, operate on after-tax contributions. Like traditional 401(k)s, there are no income limits for participation, and the IRS aggregate limit is applicable.
Distributions from Roth 401(k) plans are not taxed so long as they meet the criteria for qualified distributions. The account must be held for at least five years, and the participant must be at least 59 ½ years old. Distributions resulting from disability or death also meet the criteria.
Through 2023, Roth 401(k)s are subject to the same required distribution rules as traditional 401(k)s, however, distributions are tax-free. Starting in 2024, because of the SECURE 2.0 law, Roth 401(k) distributions will no longer be required, which means accounts can continue to grow intact. Heirs who inherit Roth 401(k)s also receive tax-free money and must empty the account within ten years. Inherited account rules are complex, and it is advisable to seek professional advice as needed.
Read More: The Best Solo 401(k) Providers of 2023
In order to get the most benefit from your 401k plan, it’s important to know how it functions. While most participants know the contribution limits, many fail to understand distribution rules. These are particularly important because failing to follow them can result in unnecessary taxes and penalties. Another simple but significant misunderstanding that I’ve seen more than once is that a 401k is an account, not an investment. After you contribute money you still need to make specific investment selections to ensure your money is working for you.
How Does a 401(k) Plan Work?
401(k) plans are designed to help employees grow their retirement savings. Once a plan is established, it goes through a period of tax-deferred growth before an employee reaches retirement. Decades of tax-deferred compounded interest can result in significant wealth accumulation.
A 401(k) plan’s lifespan can be summarized in four steps:
- Step 1
- Employers offer a 401(k) plan in their benefits package. Some workers are automatically enrolled with a default contribution amount and an array of investments. Otherwise, you can enroll yourself and select specific investments from the plan’s various options. Key factors to consider are your investment knowledge, time horizon and risk tolerance.
- Step 2
- You contribute pre-tax money from your paycheck directly into a traditional 401(k). Your employer may match all or part of your contribution. Employer matches are the equivalent of receiving a 50% to 100% return on your money. Some employers also offer Roth 401(k)s, where you contribute money after taxes have been taken out.
- Step 3
- Contributions to the plan are invested in the selections you’ve made, and earnings fluctuate based on the performance of these investments over time. In a traditional account, both plan contributions and earnings experience tax-deferred growth until the point of withdrawal, usually during retirement. After reaching age 59 ½, you may begin withdrawing funds without a 10% early withdrawal penalty.
- Step 4
- Withdrawals from a 401(k) are taxed as ordinary income, irrespective of age. Depending on your birth year, RMDs must begin either at age 73 (for those born between 1951 and 1959) or at age 75 (for those born in 1960 or later). Older retirees initiate RMDs either at age 70 ½ or 72. The period between age 59 ½ and the RMD start date is considered “financial gap years,” during which withdrawals are optional, offering flexibility for retirees during this transitional period.
Read More: How To Find a Lost 401(k)
Pros and Cons of 401(k) Plans
401(k) plans have advantages and disadvantages. Understanding these pros and cons can help you with your financial decision-making.
- Federal Protection Under ERISA
- The Employee Retirement Income Security Act of 1974 (ERISA) is a federal law that protects retirement savings accounts by setting standards for employers. This is a good thing and helps ensure adequate plan funding. Some other employer plans, like 403(b) plans, lack ERISA protection.
- Employer Matching
- Employers can, but are not required to, match employee contributions, essentially adding “free money.” For example, if you contribute 10% of your income, they may match the full 10% or to a certain percentage, such as 4% or 6%. Employers may have specific rules, such as delaying matching until an employee is vested in the company or has been employed for a certain period of time.
- High Contribution Limits
- 401(k) plan contribution limits are much higher than those for individual retirement accounts (IRAs). In 2023, the limits are $22,500 ($30,000 for ages 50 and older) for 401(k)s compared to $6,500 ($7,500 for ages 50 and older) for IRAs.
Pros of 401(k) Plans
While there are strong advantages to a 401(k) plan, it’s important to be aware of the disadvantages before deciding to open an account.
- Limited Investment Options
- 401(k) plans typically offer a limited selection of investment options compared to, for example, IRAs held in a brokerage account. Investors who prefer a wide range of choices may consider this a drawback.
- Early Withdrawal Penalties
- If you find yourself needing to make a withdrawal from a 401(k) plan before reaching the age of 59 ½, be aware that a 10% penalty is typically applied. Additionally, surpassing the annual limit, set at $22,500 in 2023 with adjustments for the cost of living, results in a 6% penalty. To circumvent these penalties, one alternative is to consider borrowing from your 401(k) instead of making a direct withdrawal. It’s crucial to ensure strict adherence to the established rules governing 401(k) plans to avoid any unintended consequences.
- Account Expenses
- Investments within a 401(k) account typically incur maintenance fees or expenses, which can impede overall investment performance. The extent of these costs varies, with low-cost index funds or ETFs generally having lower expense ratios compared to actively managed mutual funds.
Cons of 401(k) Plans
It is important to understand 401(k) rules and how they differ from the rules of other retirement savings plans. To maximize the benefits of your plan and avoid unnecessary penalties, read all documents about your 401(k) and contact your company HR office or a financial advisor with any questions you may have.
Financial advisors can also help you grow multiple streams of tax-diversified retirement income. You may benefit from putting extra funds into a Roth or traditional IRA, taxable investment account or annuity to insure against longevity risk.
Get Your Free Guide to Annuities
Tax Treatment of 401(k)Plans
401(k) plans affect income taxes before and after retirement. The amount of tax you owe depends on the type of plan. Traditional 401(k) plan contributions are tax-deferred and excluded from taxable income when made; however, withdrawals are subject to income tax. Qualified distributions from Roth 401(k) plans are not taxed because taxes were already paid on the money before contributing to the plan.
Traditional or Roth 401(k)
A key factor in deciding which 401(k) type to choose is what you think your future tax rate will be compared to your current tax rate. Individuals who expect their tax rate to drop in retirement often select a traditional 401(k), while those who expect their tax rate to rise often choose a Roth IRA.
A Hybrid Approach
The above advice is sound; however, many people have no idea what their income and wealth will be decades in the future, or what federal tax rates will be. Another approach is to “hedge your bets” and spread 401(k) savings between traditional and Roth accounts.
Professor David Brown at the University of Arizona recommends adding 20 to your age for the percentage of savings in a traditional account, with the remainder going into a Roth account.
For instance, if you’re 30, the recommended split is half and half between Roth and traditional accounts, calculated by adding 20 to your age (30 + 20 = 50).
Read More: Alternatives to 401(k) Plans