First Things First: What Is A 401(k)?
Named for its governing section of the U.S. tax code, a 401(k) retirement savings plan is an employer-sponsored investment tool that allows workers to invest an adjustable portion of each paycheck without paying taxes until funds are withdrawn. Now a linchpin of long-term financial planning, these accounts emerged as supplements to employer-managed pension funds in the 1980s but eventually began replacing them as employers acknowledged their advantageous lower costs compared with providing years of ongoing income to retired employees.
Though a 401(k) won’t allow payees to tap into all funds at will and comes with a wealth of inflexible restrictions, employees enjoy malleable control over how investments are distributed among stocks, bonds and money-market investments. Most accounts favor “target-date” funds combining stocks and bonds of profiles that become gradually more conservative as retirement draws near. The vast majority of American employers further incentivize 401(k) investment by matching annual employee contributions up to a designated maximum percentage or dollar amount, depending on your company’s plan.
However, nearly any 401(k) agreement will provide an employer with a valuable safeguard against employees departing quickly and taking the company’s matched contributions with them: accounts virtually any account is subject to a “vesting” period of work for the employer before match funds become accessible. On the other hand, principal employee contributions vest immediately and can be withdrawn at a stiff penalty within an intricate set of rules prior to retirement.
What Is A “Defined Contribution Plan?”
Defined contribution plans are employer-provided (or “sponsored”) fiscal vehicles to help employees invest toward a financially secure retirement. Although each employee decides individually and independently how much to contribute and how to invest their payments, it is somewhat of a status quo for employers to match employee contributions annually up to a maximum dollar amount or proportionate percentage of each payee’s salary. These investment programs include:
- Separate 401(k) and Roth 401(k) plans for corporate employees
- 403(b) plans for nonprofit and public education employees
- 457 plans for municipal and state employees and qualified nonprofit workers
- Thrift Savings Plans (TSPs) designed for federal employees
How Do Defined Contribution Plans Work?
Though respectively governed by distinctive sections of the U.S. tax code, every defined contribution plan is designed to simplify and incentivize long-term investment in the same fashion. Your employer deducts your chosen contribution directly from your paycheck and deposits it on your behalf into a managed individual investment account from a limited available selection. Most employers will match your contribution up to a specified maximum dollar amount or percentage of your annual salary, and you retain ownership over the account even after your employment ends.
How Is My Money Invested Through A Defined Contribution Plan?
The actual investment process behind a defined contribution plan actually barely requires any payee to lift a finger. You simply choose an investment option offered under your plan based on information provided by your employer, and the managing brokerage handles the legwork.
You choices will usually consist mostly of various mutual funds, all of which you should evaluate alongside a trusted financial professional familiar with your long-term goals, risk threshold and how to recognize potential for returns that outpace inflation. Along the way, soundly diversifying your portfolio will eventually call for sprinkling cash or bonds among your assets to mitigate volatility.
How Will My 401(k) Impact My Taxes?
That’s the beauty of a 401(k) in particular: until you begin withdrawing funds, your personal contributions, company matches and all accrued interest are absolutely tax-free. By investing money that comes out of your paycheck before taxes are deducted, you actually decrease your yearly tax bill and bolster your take-home pay. A $100 monthly contribution on your part only shrinks your paychecks between $60 and $80 over the course of four weeks, depending on your individual salary and tax bracket.
Withdrawals are eventually charged by the IRS at your typical income tax rate. However, early withdrawals before you hit 59 ½ years of age almost always inflict a 10-percent penalty on top of the assessed taxes. A similar plan called a Roth 401(k) alternatively taxes your immediate contributions but allows your money to grow tax-free and doesn’t tax withdrawals.
What If I Choose Not To Pay Into A 401(k) Or Any Other Defined Contribution Plan?
Nobody has to fund a defined contribution plan, but you would miss out on one of simplest, most advantageous long-term investment vehicles available to the American workforce.
Make no mistake, it was a sweet time when employers themselves fully funded traditional pensions and shouldered every ounce of the investment risk and administrative steering. Predictably, that became prohibitively costly, and the 1980s ushered in the 401(k), a customizable personal account into which many companies now chip in what amounts to free pretax money on top of what their employees themselves invest. You get to decrease your income tax bill, improve your take-home pay, set aside a growing retirement nest egg without having to lift a finger and receive up to tens of thousands of dollars annually. You even get to maintain your account after you leave your company’s employ. You simply have to agree not to spend a certain amount of your yearly salary until you reach a certain age.
What Makes A 401(k) Such A Must-Have Investment Account?
You get the satisfaction of setting aside pre-tax money the IRS cannot touch until you begin withdrawals. That includes returns on your investments and bonus matching contributions from your employer. Payments into your account actually improve your take-home pay and decrease your taxable income by coming out of your check before Uncle Sam deducts his share. On top of that, your investment compounds annually as long as your funds remain untouched.
When Will I Owe Taxes On My Defined Contribution Plan?
A traditional defined contribution plan is completely tax-free until withdrawals begin. The IRS cannot touch your personal contributions, company matches or returns as long as they remain in your account. Once you begin receiving those funds, you will owe regular income taxes at your typical rate at the time of withdrawal.
Conversely, a Roth 401(k) flows in the exact opposite direction. Your contributions will be taxable, but your eventual withdrawals will always be tax-free.
What Makes A Roth 401(k) Different From A Traditional 401(k)?
Though regulated by the same section of the U.S. tax code, a Roth 401(k) offers a different approach to paying taxes on retirement investments. Specifically, contributions are initially deductible, leaving payees without an upfront tax break. However, tax-free withdrawals in retirement allow your savings and returns to annually compound without the IRS drawing a dime.
How Do Matching Contributions Benefit My Defined Contribution Plan?
What could possibly be better than a secure, profitable investment? Securely and profitably investing money given to you freely for just that purpose, that’s what.
Many companies incentivize participation in defined contribution plans by offering capped matching contributions to augment their employees’ own investments. Employer contributions can range from $0.50 per employee dollar contributed to a dollar-for-dollar match, up to a given maximum percentage of the payee’s salary or occasionally a flat dollar amount, but this is the closest many working adults will ever come to simply being handed “free” money. Like your own payroll-deducted contributions, employee matches are tax-free until withdrawn in retirement.
The main caveat: company matches almost always must “vest” over a set term before becoming yours to keep. In other words, if you leave your company’s employ before that period expires, your employer can reclaim their funds.
What Is A Vesting Period?
In essence, a defined contribution plan is no different from any other employee benefit: it should be thought of us as a reward for ongoing loyal service. To be fair, any company that offers its employees “free” money to invest through its plan without requiring any extra degree of actual work is itself making an investment in its workers’ continued service.
That’s where vesting comes into play. Whereas deductions from your own salary remain yours to keep, company matching funds typically vest at a rate of 25 or 33 percent per year before you can take every cent with you if you should leave your job. Under some plans, matching funds fully vest suddenly after three or fours of employment. If you should vacate your job before being fully vested, you walk away with, at best, only a portion of your match. Depending on the plan and your tenure of employment, you leave with only your original contributions.
How Much Should I Take Out Of Each Paycheck To Add To My Defined Contribution Plan?
Don’t limit your contributions without a sound reason. Investing every cent you can, right up to the federally defined cap, takes full advantage of your plan’s given tax breaks and improves the chances of maxing out your company’s matched contributions. As of 2016, employees under 50 years of age could contribute up to $18,000 over the course of a fiscal year. If you happened to be over the age of 50, you qualified for a supplementary catch-up contribution capped at an additional $6,000. These limits fluctuate annually to offset inflation’s gradual erosion of the value of a dollar and maintain the purchasing power of your invested funds.
What Do I Do If I Can’t Max Out My Contributions?
Even if you cannot hit the federal contribution cap, you owe it to your future self to at least pay in enough to maximize your company match. Around a quarter of 401(k) account-holders fall short of qualifying for the largest bundle of money their employers are perfectly willing to hand them for keeps with minimal strings attached. Get in touch with your benefits administrator, find out your cut-off match and budget your payroll deductions to receive every cent possible within 12 months.
I’m Not Ready To Retire, But I Badly Need My Money. Should I Tap Into My 401(k)?
As much as they are built to incentivize and streamline long-term investment on as many fronts as possible, 401(k) plans also drastically discourage prematurely burning through set-aside contributions.
With precious few exceptions, any early withdrawal before a payee hits 59 ½ years of age is charged with a 10-percent penalty and all applicable income taxes at the then-appropriate rate when the funds are received.
If left with no alternative but to call upon the nuclear option of siphoning from your defined contribution plan, borrowing against your account is likely your best option if you are quite certain you can pay back the loan in full within no more than a few years. Wait any longer, and your “loan” will be reclassified as a “withdrawal,” leaving you on the hook for the taxes and penalty. Remember, any loan will decrease the money untaxed money you have making more money for you while you await retirement. On top of that, like any loan, you will owe interest to yourself on whatever you borrow. In most cases, expect to pay a prime rate plus a percentage point. Finally, should you quit your job or be laid off, your loan will come due within several months.
In the event of an emergency, the IRS can waive the early-withdrawal penalty for funds taken out to mitigate certain “hardship” circumstances, but qualifications vary from one plan to the next. Likewise, you may qualify for penalty-free withdrawal before you hit age 59 ½ if the funds are a response to sudden disability or unreimbursed medical expenses totaling more than 7.5 percent of your adjusted gross income. That percentage increases to 10 percent for workers under the age of 65.
What Happens To My Defined Contribution Plan If I Leave My Job?
If you are laid off or quit your job, you have as many as four options to manage your current plan, though not all of them are necessarily ideal:
Transfer your contributions into an IRA rollover account managed by a discount brokerage or mutual fund company. This is hands-down the wisest decision. The managing brokerage or company you choose will administer a new account that continues your tax-deferred growth without restricting your investment options as tightly as your former plan. However, do not allow your former employer to write you a check when transferring your money. Doing so forces them to withhold a chunk of your funds for taxes. Instead, ask your new account’s manager for a rollover application and opt for a “direct rollover.” This ensures that your old company will write the firm a check directly, leaving 100 percent of your balance intact.
Shift your money into your new employer’s plan. This is a tremendously convenient option, but it isn’t available under every defined contribution plan.
Leave the money alone. If your account balance falls short of $5,000 or so, your previous employer probably will not allow you to continue saving for retirement through their plan while working somewhere else. Let’s assume they do, though. This is still not a great idea, since they probably won’t feel terribly obligated to keep you abreast of changing investment options and vital policy changes.
Cash out and receive your money as a distribution. Without a most compelling reason, this choice makes no sense when you could just as easily circle back to the first option and set up a tax-deferred IRA. By withdrawing your funds, your money no longer grows without a tax burden, you face a 10-percent penalty against any money taken out before you reach 59 ½ years old and you owe income taxes throughout the full distributed amount.
What Is the Difference Between A Roth 401(k) And A Traditional 401(k)?
A Roth 401(k) is a newer retirement-planning option for workers who would rather deal with an inevitable tax burden up front and live out their golden years without dealing with the IRS.
Under the authority of the same federal tax code section as an ordinary 401(k), these defined contribution plans levy taxes against initial contributions. However, all withdrawals after 59 ½ years of age are completely income tax-free. Until then, after-tax contributions are also untaxed while growing. Assuming your employer offers both a Roth and traditional 401(k), feel free to divide your contributions between both, but be aware that combined contributions are capped. Total contributions to a combination of 401(k) plans or an individual account of either type could not exceed $18,000 in 2016, or $24,000 with the optional $6,000 catch-up contribution available to employees 50 years of age or older. Also, you must begin regular withdrawals after turning 70 ½ years old.
Is A Roth 401(k) “Better” Than A Traditional 401(k)?
The “right” answer hinges entirely on your individual circumstances. Younger employees and those who don’t make much as it is may not benefit as much from an initial tax break but could certainly feel blessed by living out a happy retirement without the IRS taking a bite out of their savings. That would make the Roth 401(k) an option worth considering.
Conversely, a traditional 401(k)’s upfront tax deferment is no doubt an appealing perk for higher-paid employees and workers expecting to slip into a lower tax bracket right around the time they anticipate beginning withdrawals.
When in doubt, diversify. There’s much to be said for equally allocating your savings among accounts that square your taxes with Uncle Sam today and plans that defer those federal payments you retire. Talk to a financial planner about supplementing a Roth IRA with your continued contributions to a traditional 401(k) or offsetting a traditional IRA with a Roth 401(k). While you’re at it, find out if your employer offers both types of 401(k) plans. You may be able to split your contributions between both.
What Is The Maximum Annual Contribution I Can Make To A Roth 401(k)?
In this regard, a Roth 401(k) is no different from its traditional counterpart. In 2016, employees under 50 years of age could contribute up to $18,000 every 12 months. Thanks to the availability of an optional catch-up contribution worth as much as $6,000, workers 50 or older were capped at $24,000. As always, these federally established limits fluctuate annually in proportion to inflation.
How Does A 401(k) Plan Work?
Your employer will automatically deposit the amount you decide to contribute to your 401(k) through regular payroll deduction. Although your company “sponsors” your account, administration and investments will likely fall to either a mutual fund company such as Vanguard or Fidelity, possibly even an insurance company such as MetLife or Prudential. Most 401(k) plans offer at least five mutual fund options focused on a number of financial market sectors in which you can choose to invest. Several also extend opportunities to purchase the employer’s own stock.
Is There A Limit To How Much I Can Pay Into My 401(k)?
Good question. There are federally established limits capping contributions, but they shift annually in proportion to inflation’s gradual reduction of the value of a dollar. As a result, your funds will not retain their purchasing power without ramping up your deposits each year.
For example, a 50-year-old employee could contribute up to $18,000 to a 401(k) over the course of 2016. There’s a catch, though: workers over the age of 50 were allowed a maximum $6,000 “catch-up” contribution, raising their cap to $24,000. Obviously, it is always preferable to contribute whatever you must in order to max out your employer’s matching contribution.
Exactly How Is My Money Invested Through A 401(k)?
To a great extent, that is your call. Mutual funds make up the bulk of what most plans offer. Choose your investment wisely and only after carefully researching all information provided by your company – preferably, alongside a trusted financial professional.
Like most long-term investments, the most fruitful 401(k) choices focus on stocks whose returns won’t just keep up with inflation but outpace it. Meanwhile, diversifying with cash or bonds will add significant stability to buffer market swings.
How Do Matching Contributions Work?
Here’s the “fun” part of a 401(k): any plan with its salt will include capped matching contributions from your company. That’s right, in return for setting aside and investing your own wages, your employer will add typically anywhere from $0.50 to a dollar-for-dollar contribution of their own. Some companies set a strict dollar limit while others cap matches at a percentage of an employee’s salary. Others restrict their contributions to “whichever comes first.” Either way, this is free money that won’t move the needle on your taxes. Remember, you don’t pay a dime to Uncle Sam until you withdraw at retirement. Again, expect a vesting period of three or four years’ employment before the money is 100-percent “yours.”
How Does My 401(k) “Vest?”
Remember that part about company matching funds being “free” money? Well, it is and it isn’t. Think of it more as an investment in you and your dedicated service over a minimum period as the expected return. Matching funds vest at rates normally hovering around 25 to 33 percent per year, meaning more money can leave the company with you for every year you work for your employer. Some plans vest all at once after a designated anniversary has passed, allowing you to take your complete company match with you whenever you should decide to depart. Depending on your company’s plan, you otherwise might walk away with a fraction of your match or even none of it whatsoever. Consult your employer’s benefits administrator or human resources representative to gain a clearer picture of your vesting timeline before making any drastic career decisions.
Should I Accept My Matching 401(k) Contribution In Company Stock?
Although preferable to no matching funds whatsoever, this isn’t necessarily advisable. You might work for a phenomenal blue-chip company with perpetually stratospheric share prices and dividends that pay like clockwork, but the essence of investing for retirement is stability. If you do purchase your employer’s stock, limit yourself strictly to no more than 10 percent of your combined assets and build your 401(k) on a foundation of diversified investments from the start. Meanwhile, your benefits administrator should explicitly lay out your plan’s protocol for moving out of company stock.
How Do I Access 401(k) Funds I Might Need Before I Retire?
This is where being clear about 401(k) restrictions becomes essential.
Ordinarily, taking out any funds before age 59 ½ – yes, that fraction counts – incurs a 10-percent early withdrawal penalty, in addition to a traditional defined contribution plan’s standard income tax. Believe it or not, a loan may present a preferable alternative to burning through your 401(k) investments directly. It isn’t at all unusual for defined contribution plans to permit borrowing against your account with the stipulation that you pay back the full amount within a given period or owe both the income tax on what will then be considered a “withdrawal” and the percentage penalty.
Remember, a loan also cuts into money that could be earning interest and actually also forces you to instead pay interest on what you borrow. You would be giving yourself back a rate of prime plus a percentage point or so instead of compounding your earnings. Just as importantly, your loan will be due within months if you quit your job or find yourself laid off.
If all else fails, the IRS can waive the 10-percent penalty for “hardship” withdrawals, but rules vary from one plan to the next. Some will also allow you to take out 401(k) funds prior to your cutoff age in the event of unreimbursed medical expenses totaling more than 7.5 percent of your adjusted gross income (10 percent, for account-holders under 65 years of age) or sudden disability.
What Happens To My 401(k) If I Leave My Job?
You should have up to four options, depending on your plan’s unique structure:
Transfer funds to a mutual fund company or discount brokerage’s IRA rollover account
Take this option if you can. Your investments won’t be confined to your employer’s options, and your current funds can continue their tax-deferred growth. When you choose a “direct rollover” method to transition your former employer’s money to your new IRA, your old company writes the firm administering your new account a check directly. Should the check be written directly to you, the employer you just left keeps a chunk of your funds for tax purposes.
Shift your funds over to your new employer’s 401(k)
Not every company permits this. If your new employer’s plan does, it makes sense to seamlessly pour your existing principal into a new basket.
If your account balance is under $5,000 or so, your former employer might force you out of the company’s 401(k). Also, they may not exactly feel obligated to keep an ex-employee in the loop about new investment options or policy changes. As should always be the case, consult your plan’s guidelines with the clarification of a financial professional and your company’s benefits administrator.
Although definitely not recommended, you can also choose to forego the tax-deferred growth of your 401(k), resign yourself to the applicable penalties and accept the money as a distribution.
At What Point Do I Have To Withdraw My 401(k) Funds?
It doesn’t come up as often as concerns about the costs of early withdrawal from a 401(k), but yes, there is a deadline for pulling your money out. Sadly, you cannot allow interest on your contributions to grow indefinitely. You must begin at least minimum withdrawals by the time you turn 70 ½ years old. Yes, that fraction absolutely counts.
The Wrap-Up: Why A 401(k) Is A Must-Have
By now, you probably feel armed to the teeth with information and ready to start feeding your 401(k), fattening it up for a prosperous retirement. Before we close this out, let’s appreciate the six pillars of this efficient, ingenious investment tool in the plainest language possible:
Most Employers Will Give You More Money Just For Investing
That never stops sounding cool, does it? The vast majority of companies who offer their employees access to a 401(k) plan will match contributions to the tune of anywhere from $0.50 on the dollar to a dollar-for-dollar match up to a specified percentage of the payee’s salary or a flat dollar amount.
You Are Actively Increasing Your Take-Home Pay
Traditional 401(k) contributions are exclusively pre-tax payroll deductions. Before the IRS can slice out a hunk of your money, you get to set it safely aside to make money for you, none of which Uncle Sam can touch until you start withdrawing it. You may not get to spend it immediately, but you get to keep more of your wages.
Your Contributions Pare Down Your Taxes
The more money you contribute to a 401(k), the lower your annual taxable income. An employee who made $65,000 in 2016 and maxed out contributions to the tune of $18,000 owed on only $47,000 of that salary. That doesn’t even take into account company-match contributions, either.
The IRS Can’t Touch Your Returns
Once you make a 401(k) contribution, you and you alone decide when Uncle Sam can get anywhere near your returns. That’s right, your investments’ interest, dividends and capital gains are untaxable as long as they remain in your account. This goes for both traditional and Roth 401(k) plans.
You Can Defer Income Tax A Long, LONG Time
Eventually, you will have to pay the piper. Your income tax obligations under a traditional 401(k) kick in as soon as you start withdrawing funds. However, you don’t have to begin receiving regular distributions from your account until 70 ½ years of age. The ability to withdraw funds without incurring a 10-percent penalty doesn’t even kick in until an account-holder is 59 ½ years old.
A Roth 401(k) Turns Much Of This On Its Head
Then again, a Roth 401(k) presents the possibility of savoring life after work without owing a dime of federal income tax. Instead, you pay taxes on your contributions, but funds in your account grow tax-free and you won’t pay a cent against your withdrawals. Once the government has taken its share, your post-tax dollars cannot be touched.