A 401(k) is a retirement savings plan offered by many employers in the United States to help employees save and invest for retirement. Contributions are made to individual accounts, and both employees and employers can contribute. By allowing employees to put aside pre-tax dollars, 401(k) plans have become very popular retirement savings vehicles.
This article will provide a comprehensive overview of 401(k) plans, including how they work, contributions and limits, investment options, loans and withdrawals, and more.
What is 401(k)?
Put simply, a 401(k) is an employer-sponsored retirement savings plan that allows employees to save and invest a portion of their paycheck before taxes are deducted. The name comes from Section 401(k) of the Internal Revenue Service (IRS) tax code. Money contributed to a 401(k) is not considered taxable income in the year it is contributed, providing an immediate tax break.
Employers often match a percentage of employee contributions up to a certain amount, effectively giving a free return on investment. The account balance then grows over time through investment gains based on the portfolio selected by the employee from options provided by the plan. Earnings and growth are not taxed until funds are withdrawn after retirement.
401(k) History
The 401(k) was established in 1978 as part of legislation aimed at changing retirement plans. Before that point, employer-based plans were only pension plans that guaranteed income after retirement. The goal was to provide portable retirement accounts that transferred with employees if they changed jobs.
401(k)s took off in the 1980s and early 1990s when matching contributions encouraged higher participation. By the 2000s, 401(k)s had eclipsed pensions as the most common type of employer-sponsored retirement plan. As of 2020, over $8 trillion was held in 401(k) accounts across the American workforce.
401(k) Contribution Limits
One of the major advantages of a 401(k) is that both employee and employer contributions are excluded from income taxes in the year they are made. For 2021, the IRS contribution limit for employees is $19,500. Those aged 50 and over can contribute an additional $6,500 as a catch-up contribution.
Employer matching contributions are in addition to the employee limits and vary by plan. A typical match is 50 cents on the dollar up to 6% of the salary. So for an employee making $60,000, contributing 6% or $3,600 would maximize the employer match of $1,800. The combined total contribution would be $5,400.
The overall limit for employee plus employer contributions in 2021 is $58,000 or $64,500 for those 50 and older. Highly compensated employees have a maximum allowance of $290,000. Contribution limits are adjusted periodically for inflation.
What Are The Withdrawal Rules?
While 401(k)s are designed for retirement savings, some plans do allow early withdrawals with penalties:
- Withdrawals before age 59.5 trigger a 10% penalty on top of income taxes owed. Some exceptions apply like disability, medical expenses, and first-time home purchase.
- Leaving an employer requires moving funds to a new employer’s 401(k) plan, IRA, or cashing out (incurring tax and penalties). Small balances under $5,000 can automatically be cashed out.
- After 59.5, withdrawals are considered regular income but no penalty applies. Distributions must begin by age 72 to avoid a 50% penalty on the amount that should have been withdrawn.
- Required minimum distributions (RMDs) each year are mandated starting at age 72 based on account balance and life expectancy tables. Non-compliance results in a 50% penalty on the amount that should have been distributed.
What Are 401(k) Investment Options?
Employers select a lineup of investment options to choose from among stock and bond mutual funds, annuities, and other securities. Options usually span the risk/return spectrum from conservative to aggressive. Popular categories include:
- Target date funds tied to expected retirement year automatically adjust risk as you age.
- Index funds attempt to match a market index like the S&P 500 for low-cost broad exposure.- Actively managed funds employ professional managers picking stocks. Fees are higher than index options.
- Company stock is offered by some employers, but over-concentration is risky if the company underperforms.
Employees should allocate money intelligently based on their risk tolerance, time horizon, and goals. Automatic enrollment may use a target date or balanced options as a default selection.
Are There 401(k) Loans?
Most 401(k) plans allow participants to borrow from their accounts, keeping the money invested while repaying with interest. Plans establish rules like maximum loan amounts (usually $50,000 or 50% of balance), repayments via payroll deduction, and loan terms of 5 years or less.
While borrowing allows access to funds, it also defeats the purpose of retirement savings and will cost more to repay with interest. Borrowers risk defaulting on an outstanding loan if they leave their employer, triggering taxes and possible penalties on the unpaid amount. Loans should be a last resort.
How Are Employer Matching Contributions Chosen?
One of the biggest benefits of 401(k) plans is that most employers match a portion of employee contributions. This essentially doubles the return through free money. Matches usually range from 25-100% of contributions up to 3-6% of salary.
For example, a 6% match on 5% contributions provides a 100% return on that 5% savings. It’s essentially free money into retirement accounts. Contributing enough to maximize the match should always be a top priority as it boosts account balances significantly over time.
Rollovers and Conversions
Job changes offer opportunities to consolidate retirement accounts. Rollovers transfer 401(k) balances to new employer plans or personal IRAs. This maintains tax-deferred growth and allows combining multiple plans into one.
IRAs also accept rollovers, providing more investment options compared to limited 401(k) menus. High-income earners should consider backdoor Roth IRA contributions by first rolling over to a Roth after-tax. 401(k) balances can also be rolled into traditional and Roth IRAs.
Conclusion
By now you should have a deep understanding of what 401(k) plans are, how they work, contribution rules and limits, investment options, loans, penalties, employer matching, and rollover opportunities. As an employer-sponsored defined contribution plan, 401(k)s enable tax-advantaged retirement savings and investment growth over many decades.
Maximizing company matches, diversifying investments wisely based on goals and risk tolerance, and continuing contributions regularly are key to building nest eggs. Proper planning allows 401(k) balances to fund comfortable retirements. With the information provided, you can make the most of any 401(k) plan offered through your employer.
