A 401(k) plan is a popular retirement savings option offered by many employers in the United States. Named after the section of the Internal Revenue Code that established it, a 401(k) allows employees to save for retirement while benefiting from tax advantages. Here is everything you should know about this essential retirement tool.
How It Works
Employees can contribute a portion of their salary to a 401(k) account, which is then invested in a range of options, including stocks, bonds, mutual funds, and other securities. Contributions are typically made on a pre-tax basis, meaning they are deducted from your gross income, reducing your taxable income for the year. However, SECURE 2.0 requires all “catch up” contributions be taxed as Roth contributions if the employee earns over $145,000 (adjusted for inflation).
Employer Contributions
Many employers offer a matching contribution, which means they will match a percentage of the employee’s contribution up to a certain limit. For example, an employer might match 50% of the employee’s contributions up to 6% of the employee’s salary. This pre-tax match is essentially free money and can significantly enhance your retirement savings. If you’re not already contributing enough to receive the full employer match, it’s highly recommended that you do so to maximize this valuable savings opportunity. In some cases, a vesting schedule may apply and should be considered before terminating employment.
Some employers may instead offer a safe harbor contribution, which means the employer will contribute a fixed percentage of compensation even if the employee does not themselves contribute to the 401(k) plan. The contribution is pre-tax and a very nice feature if the employee cannot otherwise fund a contribution. In some cases, a vesting schedule may apply and should be considered before terminating employment.
Investment Choices
401(k) plans offer a variety of investment options, typically including mutual funds, index funds, and target-date funds. It is crucial to diversify your investments to balance risk and growth potential. Many plans offer resources or advice to help you choose the right mix based on your risk tolerance and retirement timeline.
Fees and Expenses
401(k) plans often come with fees, including administrative fees, investment fees, and individual service fees. Understanding these costs is essential, as they can impact your overall returns. Reviewing and comparing fees can help you make more informed decisions about where to invest your money.
Contribution Limits
The IRS sets annual limits on how much you can contribute to a 401(k), with additional catch-up contributions allowed for those aged 50 and older. These limits are adjusted annually for inflation, so it’s important to be aware of these limits to maximize your savings without exceeding the allowable amount. Note that the annual contribution limit is applied at the individual level, not at the employer level. So, if you change employers during the year, be sure to let your new employer know what you have already contributed towards your annual limit.
Tax Considerations
One of the primary benefits of a 401(k) is its tax-deferred growth. Unless a Roth 401(k) is requested by the employee, contributions are made with pre-tax dollars, which lowers your taxable income, and the investments grow tax-free until you withdraw the money in retirement. However, withdrawals are taxed at your ordinary income tax rate. Note that even if an employee establishes a Roth 401(k), employer contributions are always pre-tax.
Unlike an Individual Retirement Account (IRA), distributions from a 401(k) have a mandatory, minimum federal income tax withholding rate of 20%, regardless of whether that rate is higher than the individual’s effective tax rate.
Rollover Options
When changing jobs or retiring, you can roll over your 401(k) into an IRA or another active 401(k) plan. This tax-free rollover allows you to maintain the tax-deferred status of your savings and continue growing your investments.
Withdrawal Rules and Penalties
Funds in a 401(k) are intended for retirement, so early withdrawals before age 59½ generally incur a 10% federal penalty, in addition to regular income taxes (state penalty may also apply). However, there are exceptions, such as hardships, first-time home purchases, and certain medical expenses. Be sure to discuss an early distribution with your tax preparer so proper tax is withheld.
Required Minimum Distributions (RMDs)
Starting at age 72 (or 73 if you reach 72 after January 1, 2023), account holders must begin taking required minimum distributions (RMDs) from their 401(k). The amount is calculated based on your account balance and life expectancy. Failing to take RMDs can result in significant penalties.