Today I’ll tackle the question many young professionals are starting to ask – what on earth is a 401k plan? Today I’ll share the 401k plan definition and explain how it’s used in retirement strategies.
Since 401k plans were first conceived in 1978, they have grown tremendously in that time. In fact, as far as employee sponsored retirement plans are concerned in the United States of America, this is definitely the most popular type.
Retiring with enough money to lead a comfortable life when we get older is critical. So, millions of workers in the US invest their money to have a healthy retirement income when they get older. They typically invest in employer-sponsored plans for retirement, and 401k plans provide a great retirement opportunity for workers all around the country because they are flexible, easy to understand, and offered by a wide range of employers in numerous industries.
401k Plan Definition: Discover the Truth about a 401k Retirement Plan
The definition of a 401k retirement plan is very simple to understand at its basic roots. Ultimately, this is a savings account for retirement that lets employees put a portion of their salary into the account that they can invest for the long term.
In some instances, it’s even possible for an employer to willingly match employee contributions up to a certain amount. And when this happens, it’s like receiving an additional bonus or extra money on top of your current salary.
As an example, let’s say the employer is willing to match your contributions up to $5000 per year. In this case, if you put $5000 of your own money into your 401k plan, you’ll have $10,000 in your account by the end of the year because of employer matching.
Related: Why is it called a 401k?
Important Aspects of 401k Plan Accounts
Just like any investment, certain aspects of the plan are very important to investors. As far as 401k plans are concerned, the following takeaways really stand out. They include:
- Opening a 401k plan with your job is very rewarding. In some cases, your employer will match all or part of your yearly contribution. In other cases, your employer may not match any of your contribution. It all depends on the company.
- There is an annual limit to the amount of money you can invest into your 401k.
- The money deposited into your 401k from your check is used as a retirement investment. You’ll have the option to pick from a wide range of mutual funds and other options to use as your investment vehicles.
- Most 401k plans dictate that the account holder cannot withdraw funds until they reach 59 ½ years old. If you withdraw funds earlier, your taxes are due and you will suffer a 10% tax penalty.
- 401k plans are considered a qualified retirement plan. Under the IRS guidelines, this means the plan is eligible for specific taxation benefits.
Technically speaking, 401k plans fall under the category of a qualified retirement plan. According to the IRS, these qualified plans receive special tax benefits. There are two different types of qualified plans. One is known as the defined benefit plan. The other is called the defined contribution plan, which is what a 401k plan actually is.
This means that the available account balance is determined according to your contributions and the way that your investments perform. Employees have to make contributions to this plan in order for it to grow. Employers are allowed to match a portion of the contribution, but they cannot solely contribute on the employee’s behalf. Once retirement is reached, the employee is in complete control of the account balance.
In 2019, it’s estimated that about half of the employers are willing to contribute to 401k plans to match employee contributions. On average, these contributions represent about 3% of their salary.
Even better, many employers are willing to match $.50 for every $1 contributed, up to a specified limit. Other employers provide varying contributions year-over-year as part of their overall profit-sharing method. These contributions can vary depending on the employer.
Roth 401k Variation
The Roth 401k is not offered by every employer. But this option is becoming more popular as time goes by. Overall, this specific plan means the employee must pay income tax on their contributions right away instead of paying taxes on distributions in retirement age.
The good thing is you can then withdraw the money during retirement without paying any taxes on it whatsoever. The bad thing is you’ll have less money available to grow as you build up your retirement nest egg. So it’s a give or take situation and your personal preference will play a great deal into whether or not you prefer the Roth 401k variation.
Related Reading: What is a Roth IRA?
Limits on 401k Contributions
For tax year 2020, the maximum tax-deferred contribution limit is $19,500. In 2019, the maximum tax-deferred limit is $19,000. If you are 50 years old or older, you are allowed additional catch-up contribution limits of $6000 for 2019 and $6500 for 2020.
The numbers vary even more for joint contributions from employers and employees. For tax year 2019, the maximum tax-deferred limit is $56,000. For 2020, the maximum is $57,000. And if you are 50 years of age or older, with the catch-up contribution limits the amounts rise to $62,000 for 2019 and $63,500 for 2020.
Investment Options for 401k Plans
Typically speaking, when a company offers a 401k plan they usually give employees the option to choose from several different investment types. Overall, a financial services advisory group tends to manage these options. Two examples of financial services advisory groups are Fidelity Investments and The Vanguard Group.
As an employee, you have the option to invest your money into several different funds as part of your 401k plan. For the most part, this wide range of options is going to consist of mutual funds. On the other hand, other options typically tend to include bond funds, large-cap funds, small-cap funds, index funds, real estate funds, and foreign funds.
Each one of these funds characteristically has a particular growth strategy in mind as well. Many of the income funds will be conservative in nature, whereas the money will grow very slowly. Other funds will be very aggressive in nature. With these funds, the money has a chance to grow very quickly. On the other hand, there’s also a much greater risk of losing money on your investments, even if it is only temporary. And there will be funds in the middle where they aren’t too conservative or too aggressive.
Looking for Other Investment Options? Learn About a Gold 401k.
401k Plan Money Withdraw Rules
All in all, the rules for distributions of a 401k plan are very different than those applying to IRAs. In both cases, if you were to withdraw the funds early from an IRA or a 401k, you’ll pay a 10% tax penalty and your income taxes will be due.
On the other hand, you can legally withdraw from an IRA whenever you feel as long as you’re willing to pay your taxes and the tax penalty. On the other hand, you’ll need a triggering event to happen in order to receive a 401k plan payout.
The definition of a triggering event is an intangible or tangible occurrence or barrier that causes the triggering of another event. Examples include retiring, dying, or suffering a job loss. Ultimately, some type of catastrophic change must occur for the triggering event to take place.
Different examples of 401k plan triggering events include:
- the employee becomes disabled
- the employee passes away
- the employee reaches 59 ½ years old
- the employee leaves his or her job or retires
- the employee suffers from a hardship recognized as a triggering event as part of the plan
- the employee is terminated from their position with the company
401k Rules for Post-Retirement
Believe it or not, the IRS also has rules in place for 401k accounts regarding the age when you must begin taking minimum distributions. And the fact is, unless you happen to still be employed, you’ll need to begin taking minimum distributions at the age 70 ½.
With other investment retirement accounts, the minimum age can be different. And when it comes to a traditional IRA, once you reach 70 ½ you’ll still have to take a minimum distribution whether or not you remain employed at the time.
When you withdraw money from a 401k account, it is typically taxed just like ordinary income. So you aren’t going to spend any additional money for extra taxes.
As you get closer to retirement age, you might choose to transfer or rollover your 401k plan. In this instance, you may choose to roll it over into a Roth IRA or a traditional IRA. Investors appreciate the rollover because it offers them more flexibility than their current 401k account provides. Since a 401k has limited investment choices, rolling over to a traditional or Roth IRA expands investment opportunities.
If you choose to go with a rollover, you must do it right or suffer the consequences. If you initiate a direct rollover, you directly take the money from the old account and transfer it to your new account. In this case, you will not have to face any tax implications.
With an indirect rollover, you will have the money sent directly to you instead of your new Roth or traditional IRA account. In this instance, you’ll have 60 days to deposit the money without having to pay the balance of your income taxes. If you deposit the money within the 60 day timeframe, you can avoid paying a lump sum income tax fee and instead pay taxes on your distributions once you reach retirement age.
If you have stock in your employer’s company in your 401k plan, then net unrealized appreciation rules apply and you should take advantage of them. You’ll receive capital gains treatment on the specific earnings. This will provide a significantly less tax bill overall, which is certainly a good thing.
Receiving a Loan from Your 401k Plan
It’s possible to receive a loan from your 401k plan, but only if your employer permits it. But if they do allow it, the 401k account holder is allowed to borrow up to 50% of the vested balance, or they can borrow the maximum limit which is $50,000.
If an employee does borrow against their 401k plan, the repayment timeframe usually takes place within five years. If the money is used to purchase a primary home, the repayment period is often longer. It depends on the situation, the employer, and other factors.
Also, if you borrow against your 401k account you will have to pay yourself interest. The interest rates are very similar to those charged by lending institutions or loans of a similar nature. If the balance remains unpaid during the repayment timeframe, the borrower will suffer a tax penalty and have to pay taxes on their distribution.
High Earner 401k Limits
For the wide majority of people, the existing 401k dollar contribution limits are usually high enough to achieve adequate income deferral levels. As an example, in 2020 if you are a high paid employee you’re only allowed to use the first $285,000 worth of income for computing your total max contributions. In 2019, the amount was $280,000.
In this case, the employer has the option of offering non-qualified plans. They can offer their employees executive bonus plans or deferred compensation plans to help them take advantage of the full benefits of their total salary.
Other Important 401k Plan Takeaways
- A brief definition of a 401k plan is it’s a retirement account sponsored by your company for employees. The employees can contribute to this plan to use toward their retirement. Employers have the option of making matching contributions if they feel so inclined.
- 401k plan basics include: the traditional 401k plan and the Roth 401k plan. The biggest difference amongst these two plans is the way that they’re taxed.
- With a traditional 401k, employee contributions mean they pay less income tax during the year. But when they finally do make withdrawals from their 401k account, these withdrawals will be taxed.
- With a Roth 401k, the contributions made to the account are post-tax contributions, meaning all taxes are taken out ahead of time. But when you withdraw from this account during retirement, each and every one of your withdrawals is tax-free since the taxes were already paid.
Acquiring a Better Understanding of 401k Plans
Overall, since there are two different types of 401k accounts (traditional and Roth), it makes sense that there are major differences between these two accounts. As an employee, it’s up to you to have either one or the other account. Or if you have the opportunity, you can even have both types of accounts.
401k Plan Contributions Revisited
The true 401k plan definition is this plan is specifically known as a defined contribution plan. By this we mean employees and their employers both make contributions to this type of account. The dollar limit of the contributions is set by the IRS.
On the other hand, a traditional pension is very different than a Roth or traditional 401k plan. In fact, this plan is typically referred to as a defined benefit plan.
With a defined benefit plan, the employer bears the responsibility of providing a certain amount of money for the employee when they retire. Pension plans are quickly becoming obsolete and they are very rare with certain exceptions.
But 401k plans are a lot more common these days when compared to traditional pensions. Employers want employees to take on the risk and responsibility of saving for their own retirement, hence the switch to 401k plans.
In a 401k plan, the employee must choose their investments inside the account. They’ll have access to a limited amount of investment options set forth by their employer. Their options usually include but are not necessarily limited to:
- mutual funds
- index funds
- foreign funds
- real estate funds
- and more
For the most part, employees usually choose a mixture of appropriate bonds and stocks. Another option is guaranteed investment contracts supplied by insurance providers. But this is less common than typical stocks and bonds.
An Overview of 401k Plan Contribution Maximums
401K plan contribution maximums adjust periodically to take inflation into account. So the contribution limits fluctuate and this normally happens each year. For tax year 2019, basic employee contribution limits include:
- $19,000 a year when under 50 years of age
- $25,000 a year for those 50 years of age or older due to the $6000 catch-up contribution limit
And the contribution limits are going to change for the year 2020. The new contribution limits for tax year 2020 include:
- $19,500 a year when under 50 years of age
- $25,500 a year for those 50 years of age or older due to the $6500 catch-up contribution limit
When you add employer contributions to the mix, the totals also change and fluctuate based on the employee/employer contribution. The contribution limits include:
- $56,000 a year in tax year 2019 for employees under the age of 50
- $57,000 a year in tax year 2020 for employees under the age of 50
- $62,000 a year in tax year 2019 for employees/employers with matched contributions
- $63,500 a year in tax year 2020 for employees/employers with matched contributions
I’ve also created this guide on 401k investment strategies by age, so you can gauge your contributions.
Employer 401k Plan Matching
For an employer matching employee contributions in their 401k plan, they must use different formulas for match calculations.
As an example, many companies commonly provide $.50 for every $1 contributed for a specific amount of their salary. In many circumstances, financial advisors always tell employees to contribute as much as they possibly can to get the full employer match because it’s practically like getting free money.
401k Account Organizing
Whether you realize it or not, it’s possible to take advantage of both types of 401k accounts – meaning traditional and Roth – as long as your employer offers this option. You can split your contributions between the two.
Nevertheless, you are not allowed to exceed the limit of one account in total contributions between both accounts. To make better sense, if your max limit is $19,500 in 2020, you cannot exceed this contribution amount between the two accounts.
As far as employer contributions are concerned, they only allow them in a traditional 401k account. And in the traditional account, you are subject to paying your taxes upon withdrawal.
Traditional 401k vs. Roth 401k
In 1978 when 401k plans were first made available, employees only had one option to choose from. That was the traditional 401k. Everything changed in 2006 when the Roth 401k was released.
As an aside, the reason certain retirement accounts are called Roth is because of former United States Senator William Roth from Delaware. He was the primary sponsor of the legislation in 1997 that made Roth IRAs and Roth 401ks possible.
Oddly enough, Roth 401ks didn’t catch on very quickly. But now they are very popular and the wide majority of employers currently offer them. So when an employee is first approached with the subject of setting up their 401k, their first task is to determine if they want a traditional or Roth 401k, or both.
Generally speaking, most employees will enter into a lower tax bracket upon retirement. In this case, a traditional 401k means you’ll experience an immediate break in taxes because your tax bracket is lower.
On the flipside, if you believe you’ll be in a higher tax bracket when you retire, a Roth 401k is a good idea because you won’t have to pay taxes later on. You’ll already have paid your taxes before making your contributions.
As an example, if you have a low salary but believe your salary will rise substantially with time, you may decide to choose a Roth 401k. For the most part, Roth 401K accounts are a good choice if you do not want to pay tax on your withdrawals in retirement age.
It’s impossible to predict tax rates when you retire, so making one choice or another could end up turning out to be a mistake. That’s why financial advisors often tell employees to hedge their bets and put some of their contributions into a Roth 401k and the rest of their contributions into a traditional 401k, evenly divided.
Also Worth Reading: Roth IRA vs. 401k
Changing Jobs with a 401k Plan
Employees tend to leave companies with 401k plans from time to time. When this happens, you’ll have four options available to you to handle the situation. Those options include:
- Money withdrawal – this tends to be a poor choice unless you urgently need the money for something serious like a medical bill. Not only are you going to have to pay taxes during the year that you withdraw the money, you’ll also get hit with a 10% early distribution tax. The only time you can avoid this tax is if you are 59 ½ years of age or older, you’re permanently or totally disabled, or you fall under the purview of other IRS criteria as an exception to this rule.
- IRA rollover – another option is to initiate an IRA rollover instead of withdrawing the money outright. You can roll the money over to a mutual fund company or a brokerage firm. By approaching it this way, you can avoid immediately paying taxes and penalties and still retain your tax advantages. Even better, by making this switch you’ll often have access to a much wider range of choices of investments in an IRA as opposed to your typical employer-sponsored plan. There are strict rules to follow regarding rollovers and it can be costly if you get them wrong. So contact a financial institution and get them to help you avoid making potential missteps during the rollover process.
- Leave the money right where it is – you also have the option to leave the money with your old employer as long as they permit it. You can keep your 401k account opened and operating on their plan indefinitely. But the employer isn’t going to make further contributions to your account as you can already imagine. Generally speaking, this doesn’t happen for smaller accounts. It will only happen if an account has $5000 or more. With smaller accounts, former employers usually force their previous employees to move the money and put it somewhere else. If your previous employer has a well-managed plan and you are satisfied with your investments, you may decide to leave the money with them as long as you feel comfortable doing so.
- Move your money to your new employer – a final option is to move the money to your new employer. It’s possible that your new employer will have no problem allowing new employees to move previous 401k accounts onto their existing plan. Similar to an IRA rollover, you’ll be able to maintain the tax-deferred status of your account and avoid paying taxes and penalties in the interim. It’s also a good idea to move the account if the employee doesn’t feel comfortable with an IRA rollover or making their own investment decisions. In this case, they feel more comfortable letting an administrator or manager handle the investment decisions on their behalf.
As you can clearly see, the 401k plan definition is very detailed to say the least. There is so much that goes into 401k investing, which is why we’ve shared as much information on this topic as we possibly can with you today. Please read this over and use this information to your advantage to make the best financial decisions to improve your overall retirement outlook in the future.