What is a 401(k) Retirement Plan?

 

 

Posted By Ziga Breznik, Last updated: March 2, 2020

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A 401(k) retirement plan is a kind of tax-advantaged account for retirement. Employees can make contributions to 401(k) accounts through strategies like automatic payroll withholding. Some employers also choose to match those contributions to help employees build up a better retirement account. Some also choose a 401k to gold IRA rollover, where funds are transferred to a IRA where precious metals are held in custody. When done correctly, it is completely tax free.

This is one of the most common retirement plans that employers can give to an employee. It’s named according to a specific part of the Internal Revenue Code of the United States, and It’s relatively easy to understand (with a bit of information).

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Getting to Know your 401(k) plan

Let’s start simple, a 401(k) is a tax-deferred and employer-sponsored plan for your retirement. It lets you save and invest some of the money that you earn from your job, so you have a nest egg for the future. The right 401(k) plan can be crucial for retirement.

There are two different kinds of 401(k) account available today: Roth 401(k)s and traditional 401(k)s. The one that’s right for you will depend on the kind of savings strategy you want to manage.

Funds in a 401(k) are invested in everything from bonds and stocks, to mutual funds. Most people prefer to use target-date funds for their investments.

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Building a Retirement Plan With a 401(k)

People often refer to a 401(k) as something called a defined contribution plan. This basically means that both employers and employees make contributions to the account, up to a specific dollar limit that is set by the IRS. 

On the other hand, traditional pensions are referred to as defined-benefit accounts, because the employer is responsible for giving the employee a specific amount of money when they retire. Over the years, 401(k) plans have become increasingly popular, as employers have preferred to shift the responsibility of saving for retirement to employees.

Employee Responsibilities with 401(k) plans

As well as being responsible for paying towards their own retirement, employees using a 401(k) are also responsible for choosing the specific kinds of investments that they want to build their wealth with. An employer will usually offer a selection to choose from.

For instance, your employer might allow you to pick from mutual funds, stocks, and bonds. You could also use target-date funds that improve your earning potential when you’re about to retire. 

Some employers even allow you to invest in the stock of the business that you work for!

Are There Benefits to a 401(k) plan?

There are pros and cons to any retirement plan.

Whether or not a 401(k) is right for you will depend on the kind of plan you have for your future. The biggest benefits of 401(k) plans is that you get various tax advantages for saving your money for the future this way. Your cash remains protected from the IRS for as long as its in the 401k. You’ll only pay taxes when you decide to withdraw money from your account.

Additionally, the contributions you make to your 401(k) plan are made before the government taxes your income. This means that you can barely notice that you’re making contributions to your retirement account over time.

Extra Benefits

Depending on who you work for, your employer might even decide to implement an employer match strategy. This means that your employer matches either dollar-for-dollar, or half of what you contribute to your retirement – allowing you to build your account wealth faster. You also get to reduce your taxable income every year with your 401(k) too.
 

How Much Can You Contribute To a 401(k) in 2020?

The amount you can spend on your 401(k) will depend on the year. Maximums for your contributions are increased every year to account for inflation. In 2019, for instance, the limits on employee contributions were $19,000 for workers under the age of 50.

If you’re over the age of 50, then you might be able to make additional contributions to your 401(k). You could put an extra of $6,000 into your account as a form of catch-up contributions. If your employer also decides to contribute to your account, the full employer/employee cap is $56,000. It could also be 100% of the employee compensation – depending on what’s lower.

Withdrawals From 401(k)

The most important thing to remember about a 401(k) is that it does cost to take money out of it before you’re supposed to.
 
Withdrawing cash from your account before you turn 59 and a half means that you need to pay taxes on your withdrawals. This means that it’s often important to make sure that you have enough in your emergency savings account to ensure that you don’t have to tap into 401(k) plans when things go wrong. The age limit of 59 and a half applies to people using both traditional and Roth 401(k) accounts.
 

The Rules of Distributions

If you decide to pull money out of your 401(k), then you’ll be making a distribution.

Distributions are the amount of money taken from your retirement plan every year. Unlike traditional IRA accounts, where funds can be taken out whenever you choose during the year, if you’re younger than the age of 59 and a half, you won’t be able to withdraw funds from your account. 

The only way to take funds out of your account early is to pay an interest tax of 10%. However, there may be occasions when you’re allowed to pull money from your 401(k) ahead of schedule. For instance, you may need to do this when you’re changing from one job to another. 

You could also pull cash from your 401(k) if you are facing pre-determined hardship laid out in your plan, or if your retirement plan is cancelled. 

What are Required Minimum Distributions?

After the age of 70 and a half, 401(k) accounts require owners to begin withdrawing small percentages from their 401(k), using tables from the IRS.

The tables provided by the IRS are based on life expectancy.

If you’re still working, and your account is with your current employer, then you may be able to bypass this requirement. It’s best to speak to a tax and retirement account professional to find out what your options are.

The complicated rules around distribution and 401(k) plans is one of the reasons why many people make the decision to roll their account into a Roth IRA before they withdraw any money in retirement. Taking advantage of this option means that you can avoid distribution rules, and it also means that you might be able to access new investment opportunities.

Roth 401(k) vs. Traditional 401(k)?

When the 401(k) plan arrived in 1978, employees only had the traditional route available.

However, in 2006, Roth 401(k)s were introduced. These 401(k) options weren’t as popular as first, but now many employers offer them as an alternative.

Usually, employees in a lower tax bracket when they retire will go for a traditional 401(k) and take advantage of the tax break option. However, if you’re expecting to be in a higher tax bracket, then you might select the Roth option and avoid higher taxes later.

Roth 401(k) options are usually well-suited to younger people who plan on working their way up the career ladder and earning more over time. Since no-one knows what might happen to tax rates in the future, neither 401(k) is guaranteed to be the right choice.

401(k) plans and Job Changes

There’s a good chance that you’ll change your job once or twice during your career. Fortunately, your 401(k) plan will come with you when you leave. You can choose from multiple options to continue carrying your 401(k) forward, including:

  • Leaving your 401(k) with your old employer. You’ll need to keep records on this and manage other fees that can take an amount of the worth of the account.
  • Rolling your 401(k) over to a new retirement plan. Once you’ve examined the investment options offered by your new employer, you can consider moving your money into the new account. You could also consider rolling your 401(k) into an IRA.
  • Rolling into an IRA. 401(k) plans can sometimes come with limited options for investment. If you don’t like this, then you could use an IRA as an alternative, to gain more control over how you spend and use your funds.

In some circumstances, you may decide to cash your 401(k) out. It’s highly recommended that you avoid this choice, as it will mean that you’re missing out on years of compounding interest in your account. What’s more, you’ll need to pay your penalty fee too.

Bottom Line

Aside from rare employer-offered plans for pensions, the 401(k) retirement plan is one of the most popular ways to put money away from the future. The tax benefits and company-matched solutions that come with these plans make them very attractive. If you can contribute to your account, then it can grow drastically over the years.

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