What is a 401k?

One of the reasons why we work so hard on a daily basis is so we can earn enough income to retire. We all look forward to enjoying retirement either sitting on a beach drinking pina coladas, traveling to see the world, or just being able to relax in the comforts of your own home. In order to make your retirement dream a reality, you need to have a well funded retirement plan. A 401k plan is the most popular type of company retirement plan and a great tool to utilize to build retirement wealth. If you have a 401k plan at work, it may be the easiest and most efficient way to save for retirement. Let’s take a look at a 401k plan’s basics and the most commonly asked questions. 

What Is A 401k?

A 401k is a defined contribution plan offered by an employer that allows employees to make pre-tax or post tax contributions from their paycheck. The two primary types of 401k’s for employees are the Traditional 401k and the Roth 401k.  

Traditional 401k

A Traditional 401k, which is the most common option offered by employers allows for pre-tax contributions from employees. A Traditional 401k plan reduces the taxes withdrawn from the employee’s paycheck since contributions are deducted before taxes. Distributions are included in taxable income in retirement. A Traditional 401k allows you to forego paying taxes today but you must pay them at a later date. Plan participants can start taking distributions at the age of 59½ penalty free. Required minimum distributions, known as RMD’s must be taken by the age of 70½.

Roth 401k

A Roth 401k has the exact same features as a Traditional 401k with one major difference. A Roth 401k is based on post tax contributions by employees. You forego the lower tax liability and pay your ordinary taxes today but there are no taxes upon distribution tomorrow. That means you never have to pay a dime in taxes for qualified withdrawals that begin at age of 59 ½. Roth 401k’s do have required minimum distributions at age 70½ but this is easily avoidable by performing a rollover. Rolling a Roth 401k into a Roth IRA allows you to get around the RMD requirement and still avoid any tax liability. 

It is possible to have both types of accounts if your employer allows it but combined contributions can’t go beyond maximum contributions.

401k Frequently Asked Questions

How much can you contribute to a 401k plan?

The maximum amount that you can contribute to your 401k plan each year changes periodically, based on adjustments to the cost of living. As of 2019, it is $19,000 if you are under the age of 50 or $25,000 if you are 50 and up. The additional $6,000 per year that those over 50 can contribute is known as the catch-up provision. Contributing to a 401k is simple as employers generally take money out of your paycheck on paydays and automatically transfer it to your 401k account.

Sometimes, the company you work for contributes to the account using a concept called employer match. For example, your employer might add $1 for every $1 you put in, up to a certain amount. Your employer can match your contributions up to $56,000(total of employer and employee contributions) or up to 100 percent of your salary. This is as long as your salary does not exceed the $56,000 threshold. Most employers match between 3 to 6 percent of an employee’s salary.

If you receive an employee match, it is always recommend that you contribute enough money every year to receive the full employer match. That is free money that your employer is offering!

What is my money invested in?

You do not have any control over your 401k plan company or the investment options. Those depend on the 401k administrative company selected by your employer. Most companies outsource the managing of 401k plans and hire administrators who email updates about the plan and its performance, take care of the paperwork involved, and assist when it comes to requests. It is up to you to select from the investment options offered by your 401k administrator.

Aim to diversify your portfolio in the 401k. Diversify your portfolio by selecting a mixture of mutual funds composed of stocks, bonds, and money market investments. You can also look for target date funds that provide a mixture of stock and bond diversification. Never invest more than 20% of your retirement money in any one mutual fund, stock, or bond. Spread out the risk by having a minimum of at least 5 different investment funds. 

Monitor your funds performance on an annual basis. Evaluate the funds expenses, which should be under 1 percent annually. Readjust your portfolio as your asset allocation changes. If your fund becomes too stock heavy, purchase more bond funds. If it becomes invested in too much small cap growth or high risk investments, reduce your exposure. Remember that you have to be the 401k manager of your 401k fund. Read the Best Way To Invest 100k for tips on diversifying your portfolio.

 

What does it mean to be vested?

Vesting refers to the ownership of the money in the account. All contributions made by you are 100% vested right away. You own your contributions so you can take them along if you leave your employer. Your employer’s contributions, however, don’t belong to you until they have also vested. Employers might follow different vesting schedules depending on the terms of their plan. In some plans, employer contributions vest immediately, while in others it can take up to six years before they become 100% vested. It is necessary to check on your employer’s vesting schedule before leaving. All employees must be 100% vested by the time they reach retirement age under the plan. All employees are also vested if the plan is terminated.

What happens to your 401k plan if you change jobs?

There are four possible options for a 401k plan if you leave your current job: 

1. Keep the account with your current employer.

Some companies allow you to keep your 401k plan even after leaving but you can no longer make contributions and no longer receive matching funds. You can select this option, if you don’t wish to leave the account with your ex-employer but don’t feel comfortable managing it on your own. You need to check first if your new employer actually offers this option. . 

2. Move it into your new employer’s 401k plan.

Another option is to move your plan to your new employer’s 401k plan which gives you the option to continue contribution and receiving matching funds again.

3. Roll it over to an IRA at a mutual fund or brokerage company. 

An IRA rollover could be your best move if want more control over how and where your money is invested. You can roll your money over to an IRA and gain greater control over your investment choices. You will however lose the ability to obtain matching funds from an employer. To be on the safe side, go for a direct rollover – the current 401k plan administrator makes the payment directly into your new IRA.

4. Cash your plan out.

You could cash in the amount, but taxes (and possibly penalties) are levied, so you have less money available when you retire.

What are the tax benefits of a 401k?

As mentioned earlier, the money that comes out of your paycheck to fund a Traditional 401k account isn’t eligible for taxes till you eventually withdraw it. The earnings, interest, and dividends that your account earns will also grow on a tax-deferred basis and not be taxed until you withdraw them. Traditional 401k accounts are best for those who expect their income to go down at the time of retirement as the deduction reduces your taxes now, and the withdrawals years from today are likely to be taxed at a lower rate than you are currently paying.

Roth 401k’s are better for those who wish to withdraw their contributions and earnings tax-free if in retirement. 

What are qualified distributions?

Qualified distributions are those made after the age of 59½. These distributions are only subject to ordinary income taxes. Withdrawals before this age are subject to a 10% early withdrawal penalty. There is also the Internal Revenue Service Rule of 55 which is a special provision allowing for penalty free withdrawal from a 401k for anyone who is 55 years or older and has been fired, quit, or been terminated by their employer.

Plan participants in need of funds can take hardship withdrawals penalty free for events such as medical emergencies, disabilities, funeral expenses, foreclosure, home purchase, college tuition, You must however demonstrate an “immediate and heavy need” to qualify for a hardship withdrawal. It is better to take a 401k loan to meet liquidity needs because you can do so income tax free if you repay the loan within 5 years. A 401k loan has the added benefit of allowing you to pay interest to yourself.

What are required withdrawals from a 401k account?

 When you are 70 and a half years of age, it is generally required that you start making withdrawals from your 401k account and paying taxes on them, following an IRS formula based on your age and life expectancy. The IRS explains these required minimum distribution, or RMD, rules on its website and has tables showing how much you are supposed to withdraw each year.

Are there any other types of 401k’s?

Solo 401k

If you are self-employed with no employees, you can establish an individual 401k plan just for yourself and your spouse. You can make contributions as both an employer and employee of your company. The maximum is 25% of your net earnings from self-employment, and your total employer and employee contributions but can’t exceed $56,000 or $62,000 if you are over 50. 

SIMPLE 401k

A SIMPLE 401k is for small business owners who have under 100 employees. A SIMPLE 401k requires employers make a matching contribution up to 3% of an employees pay or a non-elective contribution of 2% of each employee’s pay. All contributions vest immediately.

Safe Harbor 401k

A Safe Harbor 401k plan vests the contributions of employers automatically. Safe Harbor 401k’s have less annual compliance requirements than other 401k’s.

Remember that planning for your retirement is not your employer’s job; It’s yours!

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