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What is a 401(k) Plan?

401(k) plan
7 Minute Read

A 401(k) plan 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. A 401(k) plan may be offered by employers, or individuals who are self-employed may open a Solo 401(k) plan. Additionally, a 401(k) plan can be traditional or a 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 2021 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 401k

You may hear of the Roth 401(k) as more companies offer it as a retirement savings plan. In the past, when companies offered a retirement plan, it would be the traditional 401(k) Plan, also known as the Employer 401(k). These days, more than half of companies provide the Roth 401(k) in addition to the Traditional plan.

The Roth 401k

A Roth 401(k) is an employer-sponsored savings plan that combines the features of a traditional 401(k) and a Roth IRA. The two 401(k) plans share many similarities. First, you must be employed in order to qualify for either plan. They both limit how much you can contribute and if you make an early withdrawal, you will be penalized outside of the exceptions for early withdrawals.

However, the Roth 401(k) contributions are made with after-tax dollars. In other words, you pay your taxes upfront up to the contribution limit, like the case of a Roth IRA. Contribution limits are based off the age of the participant. The result of paying after tax dollars is, you aren’t subject to taxes upon withdrawal as a distribution.

This is the main difference between the traditional vs Roth 401(k). This makes it the more beneficial plan for individuals who believe they will be in a higher tax bracket at the time of distribution.

As previously stated, the availability of the Roth 401(k) has increased steadily over the years. As a result, sixty percent of people who have the option of a traditional vs Roth 401(k) choose Roth, with Millennials favoring the Roth 401(k) more than Baby Boomers and Gen Xers.

Related: The Roth 401(k) Secret

The Traditional 401k

traditional 401(k) is an employer-sponsored savings plan named after the income tax code that created it. All contributions you make to the plan are made with pre-tax dollars. Taxes are deferred, which means you will pay taxes on contributions and earnings only at the time of withdrawal.

Some employers will match a portion of your contributions – this contribution will also be deferred until you reach retirement age and make a distribution. The traditional 401(k) is a more beneficial plan if you anticipate being in a lower tax bracket at the time you take out your retirement funds.

Traditional vs Roth 401k

Neither plan is necessarily “better” than the other. It all depends on the plan participant and his or her current and future financial situation. If you expect to be at a higher tax bracket when you take out your retirement funds, you may benefit more from a Roth 401(k).

Many investors and financial advisors do prefer the Roth. Consider this: if you put $5,000 into your Roth 401(k) and you pay taxes on that amount now, that $5,000 may turn into $50,000 through wise investments. Therefore, you can take out that $50,000 tax-free as a distribution.

Let’s apply the same situation to the traditional 401(k). Let’s assume you make wise investments over the years and your $5,000 turns into $50,000 – a large portion of that will go towards taxes once you take your retirement funds out as a distribution. In that respect, in the battle of traditional vs Roth 401(k) Plans, the Roth 401(k) is the financially savvier option. That’s why many financial advisors will say, if you can pay taxes now, do so.

The Solo 401k

Self-employed individuals have fewer retirement options, like the employer-sponsored 401(k) retirement plan.

In the past, if you were self-employed or a small business owner with no full-time employees, you would choose the SEP IRA. The features of the SEP IRA are similar to a 401(k), with a much easier set up and administrative rules than the 401(k). Additionally, the Solo 401(k) is more beneficial for self-employed individuals.

However, with the rise of the Solo 401(k), also known as the Individual 401(k), more self-employed individuals opted for this retirement plan. Compared to the traditional 401(k) and SEP IRA, the Solo 401(k) has higher contributions (you can make contributions as employer and employee); you can also take out a tax and penalty-free loan, and there is a Roth option.

The Solo 401(k) must be mentioned, as it’s the ultimate retirement plan for self-employed individuals, such as small business owners and contractors.

Related: Why Choose a Solo 401(k) vs. a SEP IRA?

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.

*It is important to note that not all 401(k) providers offer a loan feature. While IRA Financials Solo 401(k) offers a loan feature, it is important to check with your provider before assuming a 401k loan is allowed in your plan.

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 3.50% as of March 28, 2022. 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 you’re under age 59 1/2.

Learn More: Solo 401(k) Loan

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.

Related: Jobs Anyone Can Do to Qualify for a Solo 401(k)

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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[10:44 PM] Valerie Marszalek-Boik