What Is a 401(k)?

For many people, thinking about retirement is not something they do often. If you are an employee, your employer may be able to help you. A 401(k) is a type of retirement account commonly set up by an employer to help employees save for retirement. It is a tax-advantaged account, which means you benefit from tax savings when you use your account for retirement income. It’s important to understand how it works. And, with several types out there, it is also important for you to choose the right type of retirement account for your needs.

How Does a 401(k) Work?

With over 50 million U.S. employees participating in 401(k)s, it’s no doubt that this is a common type of retirement planning strategy. These are employer-sponsored retirement plans. That means these plans are designed to allow your employer to establish the account for you and, then, the employee can fund it. Many times, employers help to fund these accounts, too, as a type of benefit to working with the company. In the U.S., there’s over $4.5 trillion worth of assets tucked away into these accounts. And, with over 500,000 different company plans, it’s easy to see why so many people need to know what a 401(k) is and how it works.

The term, 401(k), refers to the specific section in the Internal Revenue Code that describes this type of retirement account. These are called defined contribution plans. You do not have to elect to use your 401(k) if an employer offers it. However, if it is available to you, using it may be one of the best ways to save for retirement. This is a voluntary program, and the details of it are also flexible.

Taxes on 401(k) Investments

One of the most important things to know about the 401(k) is that it is funded with pre-tax dollars. That means, before your employer calculates the taxes you owe on your income for that pay period, they withdraw the funds for your 401(k). The funds go into the account as pre-tax earnings. Then, they are taxed when you withdraw them later on during your retirement years.

The benefit here is that most people will have a lower income tax bracket later in life than they have during their active working years. The lower income tax bracket means that you will pay less on taxes overall on these funds than if you invested after being taxed.

How Much Can You Contribute?

Unlike other types of retirement accounts, 401(k) offers a bit more flexibility in the amount you can contribute each year. The IRS does place limits on this. However, it tends to be much more than what an IRA or Roth IRA limits. For the tax year 2019, for example, individuals are able to contribute $19,000 to their 401(k). If you are over the age of 50, you can add another $6,000 to this, for a total contribution of as much as $25,000. This additional amount of investment opportunity is called a catch-up payment. It is designed to help you to get more money into your retirement account as you get older.

In many types of 401(k), the employer contributes to your plan. For example, your employer may elect to match your contributions into your account up to a certain amount each year. If this occurs, your contribution limit is even higher. In 2019, employer contributions and total investments could be as high as $56,000 per year. If you are over the age of 50 and received employer contributions, your limit was $62,000 in 2019.

Contribution limits rise each year. They generally rise according to inflationary rates. These are set each year by the IRS.

How Is Money from a 401(k) Withdrawn?

When the time comes, withdrawing funds from your 401(k) doesn’t have to be challenging. As noted, you are taxed on those funds when you withdraw them from your account.

When Can You Withdraw Funds?

The IRS allows 401(k) holders to begin withdrawing funds by the time they reach their legal retirement age. This age is dependent on the year you were born. Most often, you can begin withdrawing funds at the age of 59 ½ years. At this point, you are able to take out as much as you would like to.

Withdrawing Before the Age of 59 ½

As a retirement account, the benefit of using a 401(k) is to put money away for your retirement years. That is where the tax savings come in. And, that is also why if you withdraw funds from your account prior to 59 ½ years of age, you are likely to face penalties for doing so. You will pay the normal taxes at the rate you qualify for at this time. And, you will also have to pay a 10 percent penalty on the funds you withdraw as well. That could mean losing as much as 20 to 40 percent of the value of the withdrawal just to taxes.

After the Age of 70 ½

By the time you reach the age of 70 ½ years of age, you will need to start withdrawing funds from your account. These are called required minimum distributions. If you do not begin to take funds out at that time, it can lead to a tax penalty.

One way to avoid this is to keep working. If you are working beyond the age of 70 ½ years old, you are not required to make required minimum distributions. This is only true of the 401(k) that you have at your current employer. If you have a 401(k) from a previous employer, though, you still have to start taking contributions by the time you reach 70 ½ from those accounts.

Breaking Down 401(k) Features

401(k)s offer a variety of features to those who hold these accounts. As noted, if a 401(k) is available to you, it is a good idea to learn more about it to determine if it is a good fit for your long-term retirement planning goals. In nearly all situations, it can be. Here are some of the key features that help it to stand out.

Matching Contributions from Your Employer

Your employer sets up the 401(k) for you. Many times, they cover the costs associated with the 401(k). If not, the costs are spread out over all employees, keeping them very low for you to pay. The employer is also able to contribute to your 401(k).

For example, you can contribute your pre-tax earnings to your 401(k) up to a certain amount. You determine the amount you wish to contribute. The employer automatically funnels those payments to your 401(k). Some employers will match the amount you contribute, up to a certain amount. They do not have to do this, but those that do are putting tax-free money into your retirement account on your behalf.

Some employers make matching contributions based on your annual earnings. They may contribute, for example, 5 percent of your earnings to a 401(k). These are not funds from your paycheck – but additional funds paid to you. Others will match your contribution dollar-for-dollar. If you deposit $100 with every paycheck, they add another $100 to it.

Another interesting way your employer can help you is by contributing profit from the company. If your company offers profit sharing, they may contribute a set amount of money based on the profits the company earns. These funds can go directly to your 401(k).

The Tax Advantages

We already mentioned one of the tax advantages of the 401(k). When you deposit money into the 401(k), the funds are pre-tax. You pay them later in life when you withdraw the funds. For that reason, you are likely to pay less since most people make less during their retirement years and, therefore qualify for a lower income tax bracket.

Another benefit is that your contributions are exempt from your current federal income tax. That means that when you contribute to your 401(k), those funds are not included in your income taxes for the year. This means you will have a lower tax level for the current year as well.

Protection from Creditors

Many retirement accounts offer key benefits to protect funds from creditor access. Let’s say that, in a few years, you begin to struggle with a creditor. Your creditor may try to take your assets to repay your debt. However, the funds in your 401(k) are protected. They are never accessible to any creditors. These plans are a part of the Employee Retirement Income Security Act. Even a judge cannot rule that the funds from these accounts are accessible to a creditor.

There is also some protection from access to 401(k) funds from the federal government. If you have a federal tax lien, for example, the government cannot take a claim of your 401(k) to pay those taxes. That’s because, legally, the 401(k) is structured to remain in the ownership of the employer, not the employee, therefore making it hard for anyone to access those funds. There are some limits here, though.

What Is a Roth 401(k)?

As noted, there are several other types of 401(k) accounts. Some of these may be acceptable to you over time. One of the most common is the Roth 401(k). Many companies are offering this type of retirement account instead of the traditional 401(k). The Roth 401(k) is much like the Roth IRA, a type of individual retirement account that you can set up for yourself.

In the Roth 401(k), the contributions that are made to the account are made after taxes are applied to your earnings. That is, your employer calculates the taxes on your earnings and, after deducting them, then withdraws money from the remaining amount to invest in your retirement account.

The withdrawals from a Roth 401(k), then, are tax-free. Because they are taxed going in, they are not taxed going out. There are several limitations here. For example, the hard limit on contributions is $19,000 for 2019, and an additional $6,000 for those who are over the age of 50.

A Roth 401(k) may be beneficial to some people. If you are a high wage earner, you can access the Roth 401(k). By comparison, there are income restrictions on those who wish to open a Roth IRA. That does not apply here. You do not have to worry about making too much to qualify for the benefits of a Roth 401(k).

What Are 457 Plans?

Another type of retirement account that works much like the 401(k) is a 457 plan. Both plans work in the same basic way. The money that goes into them is pre-tax dollars. The money is then withdrawn at 59 ½ years of age or later and taxed at that time.

The difference in a 401(k) and a 457 plan is who can access them. The 401(k) is accessible by employers, including private, for-profit companies. By comparison, the 457 plan is a type that is offered by state and local public employees. In addition, some nonprofit employers also offer these types of accounts.

Frequently Asked Questions About 401(k)s

Take into consideration a few common questions individual ask about 401(k)s. It is important to talk to your financial planner for information on your situation.

Can You Have a 401(k) and an IRA?

The answer to this is yes. You can have more than one type of retirement account. Many people with a 401(k) choose to open a Roth IRA to take advantage of both pre-tax and after-tax benefits.

Is a 401(k) Safe?

The value of the 401(k) is dependent on how well the underlying securities do. Though they are relatively safe because they are diversified with numerous types of investments such as stocks, bonds or ETFs, there is risk associated with them. The key benefit here is that you can choose how risky you want to be. You can allocate your investments as they fit your goals.

Who Should Consider a 401(k)?

If you have an employer offering a 401(k), especially if there is a matching contribution, this tends to be a good option for retirement planning. Anyone with access should consider it among all of their options.