What is a 401 (k)? Definition, contribution limits, basic principles
- A 401 (k) plan is an employer-sponsored retirement plan where employees can contribute their pre-tax income, up to a limit, where it can grow tax-free.
- There are two types of 401 (k) plans: traditional 401 (k) plans funded in pre-tax dollars and Roth 401 (k) plans funded in after-tax dollars.
- It is possible to withdraw money from a 401 (k) earlier, but you will have to pay taxes and penalties.
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Everyone knows the importance of saving for retirement. According to a 2020 TD Ameritrade study, most Americans expect to retire at age 67 and more than half have a plan in place to do so. If you’re one of those wondering where to start, you may have considered a 401 (k) as an option.
A 401 (k) is one of the many retirement vehicles that can help you plan for the future. Here is what you need to know.
What is a 401 (k)?
A 401 (k) plan is a tax-advantaged retirement account offered by employers in the United States. This retirement vehicle is named after section § 401, subsection k, of the United States Internal Revenue Code.
This type of account allows employees to save for their retirement by contributing a portion of their income over time. Contributions are made by payroll each pay period. Employees can choose to contribute a percentage of their salary or a fixed amount up to a certain limit. These investment vehicles are tax-efficient which means they reduce your taxable income since they are funded with pre-tax money and the account funds grow tax-free.
Some employers contribute to employee 401 (k) plans by offering an employer match. For example, an employer may offer to match an employee’s contributions dollar for dollar, up to the first 5% of the employee’s salary.
Employer contributions often come with conditions, such as a vesting schedule. Vesting means that employer contributions and the income from them are not the property of the employee until certain conditions are met. Most of the time, employers require employees to be employed for a set period of time before all employer contributions and earnings become the property of the employee.
Types of 401 (k) s
There are two types of 401 (k) plans: the traditional 401 (k) and the Roth 401 (k) s. Not all employers offer both types of 401 (k) plans.
Here is how they work:
- Traditional 401(k) plans: Traditional 401 (k) plans allow employees to deposit pre-tax dollars into their account, reducing their taxable income. However, withdrawals from the account will be taxed. In general, this type of 401 (k) is ideal if you expect to fall into a lower tax bracket in retirement when receiving taxable distributions.
- Roth 401(k) plans: The Roth 401 (k) plans are the opposite in that they are funded with after tax dollars. There is no tax break when funded, but you won’t have to pay tax on withdrawals later in retirement. Contributions and income grow tax free.
401 (k) annual contribution limits
For 2021, the maximum amount an employee can contribute to a 401 (k) is $ 19,500. Employees aged 50 or over can make a catch-up contribution of $ 6,500 for a combined total limit of $ 26,000.
These limits apply to both traditional 401 (k) plans and Roth 401 (k) plans, even if you split your contributions between the two. If you change employers during the year, your total 401 (k) contributions cannot exceed this limit.
Another important thing to keep in mind: 401 (k) contributions cannot exceed an employee’s income. For example, if you earn $ 15,000, you cannot contribute $ 19,500 to your 401 (k) plan.
However, employer contributions are not subject to this ceiling. Overall, employee and employer matching contributions cannot exceed $ 58,000 (or $ 64,500 for employees 50 years of age or older). Some employers allow employees to make after-tax non-Roth contributions, which are subject to this limit.
Here’s a quick rundown:
Rules for withdrawing money from a 401 (k)
If you’re looking to withdraw money from a 401 (k), keep in mind that there will be taxes – and even fees – to pay, depending on what type of 401 (k) you have, your age and other factors.
Let’s take a look at each scenario in which you can withdraw funds before retirement:
How to avoid withdrawal penalties
While 401 (k) plans allow your savings to grow until retirement, there are ways to access the money sooner. Just keep in mind that it will cost you, both in penalties and lost income later.
Money withdrawn from a 401 (k) plan before age 59.5 will be subject to a 20% federal income tax and an additional 10% penalty from the Internal Revenue Service (IRS) . This means that if you withdraw $ 5,000, your plan administrator will withhold $ 1,000 (20%) and you owe the IRS $ 500 when you file your taxes, leaving you with $ 3,500.
While you can’t avoid federal income tax in most cases, there are ways to avoid the 10% penalty in certain situations:
- A permanent handicap: If you need to withdraw funds due to permanent disability, you will not be subject to the 10% penalty.
- Division of property during a divorce: Funds that must be withdrawn during the division of assets during a divorce are not subject to the penalty.
- Qualified military reservists: Those called up on active duty for at least 180 days can make withdrawals without penalty.
- Rule of 55: If you quit your job, are laid off or fired at age 55 or over, you can avoid paying the early withdrawal penalty.
- Election “substantially equal periodic payments “: A special provision allows you to withdraw a specific amount from your 401 (k) each year for five years or until age 59.5, whichever comes first. There are many rules with this option, so it is best to work with a qualified financial advisor.
- Withdrawal of difficulties: If you can prove to the IRS that you have immediate and significant financial need, you may be eligible for a hardship withdrawal to pay for eligible medical expenses or to repair your home after a disaster.
- Upon death: Distributions made to a beneficiary or an estate on or after your death are not subject to the penalty.
- IRS taxes: If you owe the IRS money, you can make a withdrawal without penalty to reimburse Uncle Sam.
- Birth or adoption: You can take up to $ 5,000 without penalty to pay for an eligible birth or adoption.
- Financial difficulties related to COVID: The CARES (Coronavirus Aid, Relief, and Economic Security) law allows up to $ 100,000 to be withdrawn from a 401 (k) account without penalty due to financial hardship related to the COVID-19 pandemic. This only applies to withdrawals made during the year 2020.
- Work plan: If you transfer your account to another pension plan within a certain period of time, you can avoid the 10% penalty.
Rules after retirement
Once you reach the age of 59.5, you can access the money in your 401 (k) account without paying a penalty. Depending on the type of plan you have, you may have to pay income tax on distributions.
“In practice, most people transfer their 401 (k) to an IRA before or during retirement,” says Sean Mullaney, CPA and financial planner at Mullaney Financial & Tax. They can choose the financial institution where they renew the money and will have access to a wider variety of investment options than those offered by most 401 (k) plans.
Starting at age 72, individuals should start withdrawing the minimum required distributions, called RMD for short, from their 401 (k) account. If they are still working for an employer at age 72 or over, they will not need to take RMD. Mullaney says that this exception generally does not apply if the employee has a substantial interest in the employer.
How to open a 401 (k)
Getting started with investing in a 401 (k) is pretty straightforward. You will need to create your account with your employer and decide how much of your salary you want to contribute each month.
The 401 (k) plan administrator provides employees with investment options such as mutual funds, index funds and exchange traded funds. You can decide which funds to invest in and how much of your contributions to invest in each fund. For example, you can decide to divide your monthly contributions between a total market
and a bond index fund.
Investment options vary from plan to plan. It’s important to look at the fund’s performance and choose funds that match your risk tolerance and long-term goals.
401 (k) loans
Sometimes you may need early access to your 401 (k) funds if something does happen. In this case, you can take out a loan against your balance, called a 401 (k) loan. You can borrow up to 50% of your acquired balance or $ 50,000, whichever is less, while avoiding penalties. You will have five years to repay the loan, but it may be different depending on your plan rules.
The good news is that you won’t be permanently depleting your retirement savings and any interest you pay will go back to your 401 (k). However, you will need to pay the origination fee. And if you can’t repay the loan within the allotted time, the IRS considers it a distribution, so you’ll have to pay income tax and the 10% penalty.
If you quit your job, are laid off, or are fired before repaying the loan, the plan sponsor may require you to repay the outstanding balance immediately. If you don’t, it may be reported to the IRS as a distribution and subject to federal tax and an early withdrawal penalty.
The financial report
A 401 (k) account can be a great way to save for retirement and minimize your tax burden. It allows you to save for your retirement in a tax-efficient manner. Since the money is automatically deducted from your paycheck, it’s easy to save. Many employers also offer a match, which allows your retirement savings to grow faster. You should always contribute enough to your 401 (k) to capture the entire employer each year if you can. This is free money, if you stick to the vesting schedule, and is part of your total compensation.