Have you ever thought about how you will support your lifestyle after retiring? Are you looking for retirement plans but can’t seem to make head and tail of them? Our guide breaks down the basics of Americans’ most common retirement plan: the 401(k).
This account allows you to contribute to your retirement so that – if used properly – enable you to have a nice nest egg by the time you retire and no longer work. You need to understand the basics of a 401(k) to understand better how it works and make the most of it.
What is a 401(k) plan?
The 401(k) gets its name from the section of the United States Internal Revenue Code pertaining to so-called “Cash or Deferred Arrangements.” The most important part of Section 401(k) pertains to so-called Defined Contribution accounts.
As the name implies, a Defined Contribution account is one whereby an employee directs a certain portion of one’s gross income to be contributed directly to an account specifically designed for retirement purposes. Because a 401(k) account is centered on pre-tax contributions, such an account is typically offered through one’s employer.
Unlike the retirement amounts afforded to retirees of traditional pension plans, the size of one’s retirement in a 401(k) account will be determined principally by how the employee contributes and invests his or her account. This has major implications for how one needs to and should manage one’s 401(k) account.
What is a traditional 401(k)?
The most commonly available 401(k) plan is the traditional 401(k). The payments made to these plans offer a respite from having to pay taxes immediately. This means that the payment to your retirement is deducted from your entire income before any tax is charged on it.
For instance, let’s suppose Sally has a gross income of $50,000 in Tax Year 2021 and decides to contribute $10,000 to her traditional 401(k) account. Because the $10,000 contribution is treated as a pre-tax contribution, Sally’s preliminary* taxable income is only $40,000. If Sally’s effective tax rate is 40%, then this represents a savings of taxes in 2021 of $4,000.
*(Note: Sally may have other deductions and credits, so the final taxable amount may very well be lower than $40,000.)
When Sally retires and starts taking withdrawals from her 401(k) account, the entire amount is fully taxable at ordinary income rates.
What is a Roth 401(k)?
A Roth 401(k) came into play sometime after the traditional one, which is why many employers still do not offer it. In a Roth 401(k) account, the contributions come from after-tax money rather than the pre-tax money used for a traditional 401(k) contribution.
While Roth 401(k) accounts do not provide tax benefits today they provide tax benefits in the future as any withdrawals during retirement are exempt from income tax; this includes both the contributions and the growth in those contributions. In other words, a Roth 401(k) account holder who makes withdrawals will be entitled to keep 100% of the amounts of those withdrawals.
Can you contribute to both plans?
Yes, some employers offer the option of contributing to both traditional and Roth 401(k) plans. However, there are two things you should know beforehand. Firstly, most employers do not offer a Roth plan in the first place.
Secondly, even if you choose to split your contributions between these two separate plans, you will still have to observe the maximum limit that applies to a single account: for most individuals, $19,500 for Tax Year 2021 and $20,500 for Tax Year 2022. (Future year amounts are typically indexed to inflation and rounded to the nearest $500.)
Whether you should contribute to a Traditional or Roth 401(k) depends on your personal preference to a large extent. If you are looking for some immediate savings, the traditional option is more suited since you have to pay lesser tax on your income.
However, if you do not need such a benefit, you may consider making your retirement as hassle-free as possible and opt for the Roth 401(k) plan, where you pay taxes now and make tax-free withdrawals later. Please reach out to us to discuss about which plan you should invest in from trained experts.
What is “Employer Matching” in a 401(k) Plan?
Employer Matching is a benefit many companies make to their employees who contribute to 401(k) accounts. This is like a bonus: instead of getting it immediately, you can cash it at a later time. While not all companies offer Employer Matching, if your company does, you should take maximum advantage of it by contributing the maximum matching percentage.
Some employers may match every dollar you contribute with a dollar of their own, while others may give 50 cents for every dollar you make.
Others might offer a hybrid of the two matching schemes: An employer might contribute dollar-for-dollar up to a certain percentage and then give 50 cents for every dollar above a certain percentage.
Consider the case of Tom, an employee who works for Jerry, Inc. (“Jerry”), who offers the following hybrid matching scheme: Jerry will match Tom’s contributions dollar-for-dollar up to 3% and 50 cents on the dollar between 3% and 5%. Tom should contribute (at a minimum) 5% to take full advantage of Jerry’s match; Jerry will match 4% of Tom’s contributions (calculated as dollar-for-dollar on the first 3% plus 50% of the 2% between 3% and 5%).
So in a partial matching scheme, you may qualify for matching if 6% of your earnings go to the 401(k). Since your employer only matches 50 cents per dollar, for the 6% you contribute, 3% of your income is also contributed by your employer.
Can I choose where my money is invested?
Generally speaking, you will have significant say in how your money is to be invested, but unlike a traditional brokerage account whereby you will have thousands – maybe even tens of thousands – of investment options, most 401(k) plans only offer a couple of dozen choices. These options are typically diversified stock and bond mutual funds, as well as a cash-equivalent option such as a money market fund.
One investment option that has become increasingly prominent in 401(k) plans over the past decade or so is that of so-called Target-Date Retirement Funds. These funds are popular because they simplify the sometimes complex process of deciding which funds to invest in to a single question: “In which year do I plan on retiring?” The employee can then put all of his/her contributions into the Target Date fund with a year closest to his/her anticipated year.
Only in rare cases will options include more “sexy” options such as individual stocks or exotic assets like Options or Cryptocurrencies. One notable exception is that some companies will offer employees to invest in the individual stock of the company. For example, Widget Inc., might permit employees in its 401(k) plan to invest in Widget stock.
How does the money in my 401(k) grow?
The money in your 401(k) can increase over time depending on the kind of investments you make. Your 401(k) money will be invested across various stock options, and the money that the stock makes goes to your account.
The success of your 401(k) account over time will be directly correlated to the types of asset classes in which you invest. Generally speaking, higher returns will accrue to those accounts invested in Equities (i.e. Stocks) with lower returns to those accounts invested in Fixed Income (i.e. Bonds and Cash). More balanced portfolios – those investing in a mixture of Equities and Fixed Income – will have returns somewhere in between.
Is there a limit to how much you can contribute?
As indicated earlier, a traditional 401(k) account does have a maximum amount to how much you can contribute on an annual basis: $19,500 in Tax Year 2021 and $20,500 in Tax Year 2022.
However, people who are 50 or above are allowed to make a so-called catch-up contribution, enabling an individual who is – for example – 55 years old to contribute up to $26,000 in Tax Year 2021 and $27,000 in Tax Year 2022. This means that older working people are allowed to make larger contributions since their retirement is nearing, and they need to save money before they reach that point.
Do you need to withdraw money from a 401(k)?
The IRS does require you to withdraw a certain amount from your retirement accounts. These are known as Required Minimum Distributions (“RMDs”), and these must be made from a traditional 401(k) account when you reach the age of 72 for most individuals.
If, however, you are still working at the age of 72 – which is increasingly occurring – you might be exempt from making these RMDs.
When can you withdraw money from a 401(k)?
According to the rules laid down by the IRS, the minimum age one can withdraw money from a 401(k) account is 59.5 years without incurring any penalties. This is because, in most cases, a handsome amount of savings have already been accumulated into the account, making it practical to withdraw the money.
You can also withdraw money from this account if you fulfill other requirements laid down by the IRS, such as being disabled. This is because the whole purpose of 401(k) is to help you when you need it, and these conditions will usually make you eligible for these withdrawals as they may prove your need.
Can you withdraw money from a 401(k) earlier than normal?
Strictly speaking, it is possible to make withdrawals before you reach the age limit prescribed by the IRS. However, the whole purpose of 401(k) accounts is to encourage responsible saving. To prevent people from chipping away at their savings, you may have to pay a 10% early distribution tax.
This can be a hefty penalty to pay, particularly when you have to pay your routine taxes as well. This is why we tell our clients to save for everyday emergencies separately. Just plan your daily expenses and regular savings based on your income after the 401(k) contribution has been deducted. This will make you better prepared for any problems you may face and allow you to handle them without having to dip into your 401(k).
One way to avoid the penalty payment could be to take a loan against your account. Some employers give you the offer of taking a loan. However, there is a strict time limit and usually, a lump sum repayment condition that you need to adhere to if you do not want to pay the 10% tax penalty.
What are the benefits of a 401(k)?
There are numerous benefits of having a 401(k) account. The first is that your immediately taxable income is reduced in a traditional 401(k), so you make immediate savings.
The second plus point is that the deductions are hassle-free: once you sign up for this plan with your employer, he makes the deductions automatically, and you do not need to worry about anything else.
Thirdly, the earlier you start contributing to a 401(k) account, the more money you saved for retirement. Thinking about such things now will help you at a time when you need it. You will not even feel as if a chunk of your income is going to a separate account; you can plan your daily expenses around the income you get after the 401(k) income is deducted.
Lastly, and perhaps most importantly, 401(k) accounts are extremely flexible. These accounts can be transferred from one employer to another, and you can even choose how much to contribute to them.
Summary
As a working American, having a retirement plan is essential. You will not be able to work all your life, and even if you can, you may not want to. This means that you should have some savings set aside for this time.
The 401(k) account is one of the best retirement plan options since it ensures responsible saving. The money is automatically deducted, and there is a strong deterrent on immediate withdrawals, securing your money for a time when you need it.
We provide complementary advice on 401(k) plans for clients who have investment accounts with us. Please reach out to us to schedule a time to discuss a strategy for investing in your 401(k) plan.
October 08, 2021
RVW Wealth