Table of Contents
Any benefit that reduces the tax bill before the IRS (Internal Revenue Service) is valid, right? Especially if it is a tax exemption. That’s one of the main attractions of the 401(k) plan, as it allows employees to take advantage of contributions made by their employer. Let’s see below what the 401K retirement plan is.
Basically, taxpayers who use the 401K are in a win-win situation because they can use it to lower their tax liability and, at the same time, as a method of effective savings for retirement.
Table of Content
- What is a 401(k) plan?
- Characteristics of the 401(k) plan
- Types of 401(k) Plans: Understanding Their Main Differences
- Is there a limit to contributing to the 401(k) plan?
- How do employers contribute to the 401(k)?
- How do withdrawals work in the 401(k) plan?
- What are minimum distributions and how do they work?
- Traditional 401(k) Plan vs. Roth 401(K) in Detail
- What happens to a 401(k) when I leave my job?
What is a 401(k) plan?
The 401(k) plan is nothing more than a defined contribution retirement account that gives taxpayers certain tax advantages. Its name coincides with one of the sections of the country’s Internal Revenue Code, which is the legal instrument that includes retirement savings plans.
But what makes the 401(k) plan so popular with employers and employees? Mainly, your application. And it is that, workers can make automatic contributions to their 401(k) accounts through payroll withholdings, thus freeing themselves from the task of contributing to the plan on a monthly basis. In addition, employers have the option to match some or all of the contributions made by the worker, making the account balance grow progressively.
The best? Earnings earned through investments made with the 401(k) plan are not taxed until the employee withdraws the money , which is usually after retirement. Unlike the traditional 401(k), Roth 401(k) plans offer tax-free withdrawals.
Characteristics of the 401(k) plan
Among the elements that characterize the 401(k) plan versus other methods of saving for retirement, you will find:
- That the 401(k) plan is an employer-sponsored retirement account.
- That both employees and employers can contribute equally. In some cases, employers may even exceed their employees’ contribution amount.
- Which is divided, mainly, into two basic plans. The traditional 401(k) and the Roth. The main difference between the two centers on when earnings are taxed.
- That the traditional 401(k) plan allows employees to reduce their income tax by opposing contributions made during the year. However, withdrawals are taxable. This differentiates it from the Roth, since, in this case, the workers make their contributions with the net income after taxes so as not to have to pay taxes at the time of making the withdrawal.
Under the CARES Act (The Coronavirus Aid, Relief, and Economic Security Act) and due to the COVID-19 pandemic, withdrawal rules and amounts were relaxed in 2020. This decision was made to help those affected by quarantine.
Types of 401(k) Plans: Understanding Their Main Differences
The 401(k) plan is what is known as a defined contribution plan. What does this mean? That both the employee and the employer can make contributions to the account up to the dollar limits established by the Internal Revenue Service or IRS.
This is a characteristic of the 401(k) plan, since traditional pensions not to be confused with this account belong to the group of defined benefit plans. In that case, it is the employer’s responsibility to contribute a specific amount to the employee’s account to ensure that the employee has enough money at retirement.
This is precisely why 401(k) plans have become more popular in recent decades, as many prefer to opt for a defined contribution plan instead of traditional pension plans. Ultimately, the 401(k) allows the employer to pass on a share of responsibility to their employees, encouraging them to save for their future.
So much so that employees are responsible for choosing the specific investments to be made with their 401(k) account. These offerings include a variety of mutual funds, stocks, and bonds; as well as time deposits and different investment instruments that combine the purchase of shares and bonds to reduce risk.
The investment modalities allowed by the 401(k) account may also include guaranteed investment contracts -known as GICs- issued by the most important insurance companies in the country and the purchase of the employer’s own shares.
Is there a limit to contributing to the 401(k) plan?
In fact, there is. The maximum amount an employee or employer can transfer to a 401(k) account is periodically adjusted for inflation. As of 2020, the basic limits on employee contributions are around $19,500 per year for workers under age 50, and $26,000 for workers over this age limit.
If the employer also contributes or if the employee chooses to make additional non-deductible contributions to their account, they’ll need to make sure the plan allows it. If so, the total contribution would also be limited by the IRS in these terms:
- For workers under age 50: $57,000 or 100% of employee compensation, whichever is less.
- For workers over 50 years of age: $63,500 or 100% of their compensation, whichever is less.
Remember: The total limit imposed by the IRS includes both contributions from employers and contributions made by the employer.
How do employers contribute to the 401(k)?
Many employers choose to match their employees’ contributions , using different formulas to calculate the amount to contribute to the account.
One of the most common practices among employers is to contribute $0.50 or $1 for every dollar that the employee allocates to his retirement plan until a certain percentage of his salary is covered. That’s why financial advisors often advise employees to put a big chunk of money into their 401(k) retirement plans, because that way they’ll get a lot more money when the employer decides to match their contributions.
Traditional or Roth 401(K) plan. What suits me?
Some companies offer their employees to invest in a traditional or Roth 401(k). In this case, it is up to the workers to choose the option they prefer. However, there is the alternative of splitting contributions between the two plans, thus putting a portion into a traditional 401(k) and the remainder into a Roth 401(k). Of course: the total contribution to the two types of account cannot exceed the maximum limit set , which in 2020, was $19,200 for each one.
Remember: Employer contributions can only be made to a 401(k), not a Roth account, and will always be taxed at the time of withdrawal.
How do withdrawals work in the 401(k) plan?
It’s important to note that once participants choose to open a 401(k), making withdrawals can be a bit difficult. Our recommendation? Make sure you save enough each month and put the money in your own savings account or any other financial instrument of your choice to be able to deal with emergencies and unforeseen expenses that may arise before you retire.
Putting all of your savings into a 401(k) is not recommended, as access to the funds is limited and you won’t be able to access them easily, should you need them.
You should also remember that 401(k) earnings are taxable, unlike Roth earnings. Consequently, when a traditional 401(k) account owner makes withdrawals, that money—which has never been taxed—will be taxed just like any ordinary income.
Instead, the owners of the Roths accounts have already paid the income taxes associated with the contributions and, as long as they meet certain requirements, they will not have to pay any type of tax when making their withdrawals.
Are there ways to withdraw funds from a retirement plan without penalties?
Actually yes. Both owners of a traditional 401(k) plan and those of Roth accounts who are at least 59 1/2 years old or who meet other requirements imposed by the IRS – such as being declared totally and permanently disabled – can start making withdrawals without penalties. If the taxpayer does not meet any of these characteristics, they will face the payment of an additional penalty tax for early distribution equivalent to 10%, in addition to any other tax or charge associated with the withdrawal.
Special considerations for the year 2021: the CARES law that was enacted on March 27 and that includes the injection of two billion dollars; allows those affected by the pandemic to access a maximum limit of $100,000 of their funds without incurring the 10% early distribution penalty.
Account owners now also have three years to pay the tax on withdrawals, instead of paying it during the current year. However, take into account that for this provision to operate, it must have been adopted by the entity that manages your retirement plan. Our recommendation? It is best that you discuss the consequences with the plan administrator before making any withdrawals.
If you’re not sure if you’re included in these benefits, you can refund the withdrawal money to another 401(k) or IRA account. This will allow you to free yourself from the obligation to pay taxes, even if the amount exceeds the limit of the annual contribution allowed for this type of account.
What are minimum distributions and how do they work?
Both account types are subject to Required Minimum Distributions (RMDs) which is the IRS term for withdrawals. After age 72, account owners must withdraw at least a specified percentage of their 401(k) accounts, using the IRS’ national life expectancy tables. To give you an idea, in the year 2019, the RMD age was set at 70 and a half years.
Now, there is an exception to this rule. And it is that contributors who still have a job and who have their 401(k) account open with their current employer can make withdrawals before the age of 72. However, and as explained above, these withdrawals will be subject to the application of income taxes and will have a negative impact on the growth of the account fund.
Special considerations for 2020: The CARES Act suspended RMDs for retirement accounts for that year. This gave the holders of these accounts the opportunity to easily recover their previous balance and also the banking sector, which needs to raise its head after the stock market crash.
Are Roths also subject to an RMD?
Due to their particular characteristics, Roth 401(k) accounts are not subject to the same considerations as the 401(k) plan. In fact, RMDs do not apply to these special retirement savings plans, this being another difference between the traditional 401(k) and the Roth.
Traditional 401(k) Plan vs. Roth 401(K) in Detail
Traditional 401(k) plans were launched in 1978 and, for a long time, were positioned as the only available option for retirement savings. But starting in 2006, Roth 401(k)s appeared and joined the savings alternatives. The Roths got their name from the surname of Senator William Roth of Delaware, who was the main sponsor of the Roth IRA legislation in 1997.
While Roth 401(k)s were slow to make their way into everyday working lives, they are now so popular that employers often offer them in conjunction with a traditional 401(k) plan. Of course, this means that it is the worker who chooses the retirement plan of his choice: the Roth 401 (k) or the traditional 401 (k).
One of the ways that experts recommend to decide on one plan or another is to evaluate the tax burden of the worker. Employees who are in a lower tax bracket could opt for a traditional 401(k) plan and take advantage of the immediate tax break; while employees who hope to achieve a higher rank may prefer to opt for the Roth, as this way they can avoid paying higher taxes in the future.
Let’s see it with an example
A Roth might be the best choice for a young worker whose salary is relatively low, since over the course of his working life he is likely to achieve a much higher salary and, in the meantime, he could take advantage of a lower tax rate to make his contributions. and dispose of your savings without having to pay taxes in the future.
But remember: This is not a general rule. Since no one can predict the tax rates that will apply in the future, neither type of 401(k) plan is 100% certain. Precisely for this reason, financial advisors recommend that employees opt for both plans together and divide their contributions in each of the accounts.
What happens to a 401(k) when I leave my job?
When an employee leaves their job, they have four options for managing the funds in their 401(k) account. Let’s examine them carefully:
Move the funds into an IRA
If you choose to transfer your funds to an IRA, brokerage, or mutual fund instead of withdrawing, you can avoid paying taxes right away and keep your tax advantage. In addition, this type of investment and savings account will offer you a wide range of options to multiply your earnings, something that you did not have in your old 401(k) account.
Yes indeed, The IRS has very strict rules regarding transfers of funds that establish how they must be carried out. If you need help figuring out how the transfer will be done and what associated costs you might have to cover, ask the financial institution that handles your future IRA account. Being a new customer, they will be more than happy to help you.
Warning: In order to enjoy the benefit of avoiding taxes and penalties when you withdraw your funds from your 401(k) account , you must transfer them to another retirement account within 60 days of withdrawal. Otherwise, you will face paying taxes.
Keep the fund for your new employer to contribute
Some companies allow their new hires to move their 401(k) fund into their company retirement plan. Just like rolling over funds into an IRA, you can defer paying your taxes so you don’t have to pay them right away. This could be a good option if you’re not entirely sold on IRA investment plans, as it will allow you to pass the money directly to your new employer’s retirement plan administrator.
Keep the fund with the former employer
This is an alternative that is not available in all companies, but it is in some. And it is that, in many cases, employers allow their former employees to keep their 401(k) account indefinitely. However, the employee will not be able to make any further contributions. This generally applies to accounts with an approximate value of at least $5,000. If your account has a credit balance less than this, your former employer may ask you to transfer or withdraw the funds.
Leaving money saved in your former employer’s 401(k) can have some benefits, especially if you find the plan to be very well managed and you’re satisfied with the investment options it offers. The only danger in going this route is that you completely forget that you had an active 401(k) plan with that company. To prevent something like this from happening to you, keep track of all your plans and share them with your immediate family.
Withdraw money from 401(k)
Employees who stop working are allowed to withdraw their 401(k) funds, but that doesn’t mean it’s a good idea. Think that, unless you need to increase your liquidity to pay a medical bill or face an unforeseen expense, it is the least recommended option. Remember that when you withdraw your funds you will have to pay income taxes in that same year, in addition to an additional tax for early distribution equivalent to 10%.
Can I withdraw money from the 401(k) without paying?
Now, if you are over 59 and a half years of age, have been diagnosed with a permanent disability or meet other criteria issued by the IRS for the withdrawal of funds without penalties; yes, you can withdraw your funds without having to face the consequences, since the laws protect you and your case fits perfectly into one of the exceptions to the rule.
Remember that during the year 2020, this limitation -and its exceptions- were suspended for people who have been affected by the COVID-19 pandemic. However, if you decide to withdraw some of your savings, your retirement plan balance will decrease. Therefore, you should analyze the situation very well before making a withdrawal that you may regret later.
Tip: Remember that the IRS will not tax the contributions you make to your 401(k) plan through paycheck withholding, as it considers them a deductible expense. You’ll only have to pay taxes when you make an early withdrawal or distribution, unless you roll the money over to another retirement plan, like an IRA.