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What is a 401(k) Plan?

401(k) plan

A 401(k) plan is is a type of defined-contribution plan offered by most employers. This retirement plan allows you to put away money for the future, while allowing for many tax benefits. 401(k) plans can either be traditional or Roth. The major difference is when taxes are paid. Further, your employer might offer a matching bonus that increases the funds in the plan. The 401(k) is probably the most well-known type of retirement plan and is generally the first plan that people will contribute to.

Contributing to a 401(k) Plan

Assuming your employer offers a 401(k) plan option, you can save for retirement with a payroll deduction. Some companies will allow you to contribute once you start working, while others may make you wait 30 or 60 days or longer before you can take advantage.

Each year, the IRS sets the annual contribution limit for all retirement plans. Depending on inflation, the limit may increase from one year to the next. For the 2020 taxable year, the 401(k) contribution limit is $19,500 or $26,000 if you are age 50 or older. Therefore, you cannot exceed those limits with direct contributions. However, you are limited to how much earned income you have. If you earn less than the maximum limit, that is how much you are allowed to contribute. For example, if you earned $10,000 during 2020, you may contribute up to $10,000. You cannot exceed that amount, even if you have other funds you would like to contribute.

Further, your employer might offer a company match to encourage you to save for retirement. A typical match is 50% of your contributions, up to 6% of your salary. For example, an individual earning $40,000 could see a $2,400 matching contribution. To earn the full match, you would need to contribute $4,800. It’s always best to contribute at least enough to receive the full match, if one is available to you.

Traditional vs. Roth

As we mentioned earlier, there are two types of 401(k) plans: traditional and Roth. The traditional plan is the most widely available retirement plan for employees. All contributions made to the plan are pre tax. This means you get an immediate tax deduction when you file your taxes. Those taxes are deferred until you start taking distributions during retirement. So, if you earned $40,000 and contributed $10,000 to your traditional 401(k) plan, you will only have $30,000 in taxable income for the year. Contributions are usually taken as a payroll deduction.

On the other hand, a Roth 401(k) is funded with after-tax money. There is no upfront tax break. All Roth contributions are treated as taxable income when you do your taxes. However, all qualified distributions are tax free. This includes not only your contributions, but all earnings in the plan. A qualified distribution is one taken after the age of 59 1/2 from a Roth account that has been open for at least five year. The one caveat is that your employer must offer a Roth option. Just because they have a 401(k), doesn’t necessarily mean you can contribute to a Roth.

Which 401(k) Plan is Better?

Arguments can be made as to whether the traditional or Roth 401(k) is the better option. A lot depends on personal preference, your age and your earning potential. The general rule of thumb is that the younger you are the more you can take advantages of the tax-free growth of the Roth 401(k). Further, early on in your career you will be earning less money. Paying taxes now is not a huge deal. Tax-free growth over several decades will lead to a bigger nest egg.

Obviously, the opposite is also true. The older you are and the more money you earn, the more attractive a traditional plan is. Lowering your tax bill right now may be your biggest priority. Plus. the closer you are to retirement, the less time you have to take advantage of the Roth. Lastly, it doesn’t make sense to pay taxes while you are in a higher tax bracket. If you expect to be in a lower one once you start withdrawing, you may be better off waiting to pay the IRS.

In the end, the decision is up to you and your personal financial goals. What’s more important to you – lowering your tax bill or tax-free withdrawals? The best option may be not to choose. You can diversify your retirement plan by contributing to both a traditional and Roth 401(k) plan. Pay taxes now at a known tax rate with some of your money and defer taxes with the rest. Keep in mind, the annual contribution limit applies to your total 401(k) contributions. Therefore, if you contribute to both types of plans, the total limit is $19,500, not $19,500 for each plan.

401(k) Withdrawals, RMDs & Other Rules

401(k) Withdrawal Rules

Now that you’ve saved for retirement in a 401(k) plan, when can you withdraw all those funds? Since the IRS wants you to save the money for your post-working career, it’s hard to get funds out early. First of all, you need a triggering event to withdraw the funds. The two most common events are reaching the age of 59 1/2 or separation from your job. Once there is a triggering event, you have options. If you’ve moved onto another company, you may choose to rollover the funds into the new employer’s plan. You may also choose to rollover the funds into an Individual Retirement Account, or IRA. Some companies may let you keep your money in the old plan, however that’s generally considered a bad idea.

Another option is withdrawing the funds for personal use. This should be your last option if you haven’t retired. If you are under age 59 1/2, you will get hit with a 10% early withdrawal penalty. This penalty is on top of the taxes that will be due on the amount taken. Of course, if you are above age 59 1/2, you are clear to withdraw funds without penalty. Only taxes will be due for traditional withdrawals. If you have a Roth plan, again you will be hit with the penalty before age 59 1/2, AND you will get taxed on the amount withdrawn. Once you reach that age, your withdrawals will be tax free.

401(k) plans do offer hardship distributions that will allow you to access your funds before age 59 1/2. If you become permanently disabled, have certain medical expenses or need money to avoid eviction or foreclosure, you can get penalty-free use of your funds. Note: the are other criteria that may allow for a hardship withdrawal.

RMDs

Required Minimum Distributions (RMD) are mandatory withdrawals you must start taking from most retirement plans once you reach age 72. Note: Prior to the SECURE Act, RMDs started at age 70 1/2. Both traditional and Roth 401(k) plans are subject to RMDs. Each year, starting with the year you turn age 70, you must withdraw a specific amount from your plan(s). This amount is determined by your account balance (as of December 31 of the previous year) and the IRS’s life expectancy tables.

Failure to take your full RMD during any year will lead to a 50% penalty of the amount not taken until the RMD is fully satisfied. There are a couple situations where you do not have to take an RMD. If you are still currently employed and have a plan, you do not have to take your RMD for that account only. RMDs are still required for any other retirement plan you may have. Further, since Roth IRAs are not subject to RMDs, you may choose to convert traditional funds to a Roth IRA. You may also choose to roll over Roth 401(k) funds to a Roth IRA to avoid the RMDs.

401(k) Loan Rules

If your plan allows for it, you may choose to borrow up to $50,000 or 50% of your account balance, whichever is less. A 401(k) loan can be used for whatever reason you want. The loan can be spread over five years with payments at least quarterly. The interest rate is generally a point or two above the Prime Rate, which stands at 3.25% as of May 1, 2020. All interest is paid back to your 401(k) plan.

If you miss a payment, the loan is defaulted and the outstanding balance will be treated as a taxable distribution. Therefore, you will pay taxes on the amount not repaid, and owe a 10% penalty if your under age 59 1/2.

Special Considerations

Because of the current COVID-19 pandemic, some rules have been waived for 2020. The CARES Act allows easier access to retirement funds. First, there are no early withdrawal penalties for 401(k) and IRA distributions. Therefore, even if you are not age 59 1/2, you have penalty-free access to your funds. Further, taxes on these distributions can be paid off over a three year period. In fact, if you repay the entire amount withdrawn, you will owe zero taxes.

Moreover, the RMD regime has been waived for the year. You do not have to take a distribution if you do not wish. If you failed to take your 2019 RMD, that withdrawal is also waived.

Lastly, the 401(k) loan option has been increased from $50,000 to $100,000. Loan repayments are also delayed for one year. Essentially, if you borrow from your 401(k) now, you have six years to pay back the loan. Any payments due for a current loan are also suspended for one year.

The Last Word

The 401(k) plan is an essential retirement planning tool. For most people, the 401(k) is the first plan that you will save for retirement in. The earlier you start saving and the more you can contribute, the better you will be when it’s time to retire. Properly diversifying your assets held in the plan, along with the tax treatment is a great formula for success. The tax advantages of the 401(k) make it a far better instrument for saving than other accounts.

Take advantage of en employer match, if offered, as that is like getting free money. Be sure to learn the pros and cons of both the traditional and Roth plans. Lastly, work with a financial planner to help determine your best course for retirement savings.

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