What is a 401k Plan and How Does it Work?
A 401(k) is a qualified retirement plan that employers can sponsor for eligible employees to save and invest for their own retirement on a tax-deferred basis.
Who sponsors a 401k plan?
A sponsor is a company, employer, or professional group or union that sets up a 401(k) as a retirement plan for its employees or members. As a 401(k) sponsor, the company develops the plan’s investment options and guidelines for membership, or “vesting.” The employer sponsor may also decide to contribute to its employees’ 401(k)s with cash and stocks.
What are the investment choices for a 401k?
Your sponsor will provide at least three diversified investment options. Deciding which is right for you will depend on your age, risk tolerance, goals and expectations.
What is employer matching?
Some employers match their employees’ contributions up to a certain percentage. This is free, tax-deferred money from your employer, and you’ll get it by contributing the minimum your employer requires.
Here’s an example of the difference an employer contribution can make to your 401(k):
If you earn $50,000 a year and contribute 6% into your 401(k), you will have added $3,000 in your first year. If your employer matches your contribution dollar for dollar, you would have $6,000. Let’s say your employer contributes 50 cents for every dollar you do. You would still be ending the year with $4,500 more in your 401(k). In short, make sure you contribute at least enough to secure your employer’s contribution.
Law, rules and regulations of 401(k) plans, includes contribution limits
There are limits to how much you can contribute to your 401(k). These limits can change annually, and people over 50 can contribute more. Here’s what the 2020 limits are:
- Save up to $19,5000 in your 401(k), up from $19,000 in 2019.
- Individual retirement account contributions will be limited to $6,000
- Employees aged 50 or older can take advantage of catch-up contributions. In 2020, the IRS raised the limit on catch-up contributions by $500 to $6,500 from $6,000. Each has different rules that must be followed. According to the IRS, “To qualify for the tax benefits available to qualified plans, a plan must both contain language that meets certain requirements (qualification rules) of the tax law and be operated in accordance with the plan’s provisions.” The 2020 SECURE Act also plays a role in relation to 401(K) contributions and more. Read more here.
The laws, rules and regulations depend on what kind of 401(k) you have. There are traditional, safe harbor and SIMPLE 401(k) plans. Each has different rules that must be followed. According to the IRS, “To qualify for the tax benefits available to qualified plans, a plan must both contain language that meets certain requirements (qualification rules) of the tax law and be operated in accordance with the plan’s provisions.”
What is a Roth 401k vs traditional 401k?
With a Roth 401(k) you pay taxes on the money before you deposit it to the account, not when you take disbursements. Funds in traditional 401(k)s are deposited pre-tax and will be taxed when you start withdrawing money.
Both have benefits depending on the account holder’s age, tax exposure and future outlook. These account types can be used simultaneously to limit tax exposure and balance risk and long- and short-term benefits.
How do 401k withdrawals and transfers work?
The best course of action is to wait until you retire to withdraw money from your 401(k). If you need to access the money before that, you can trigger taxes and fees. Here’s what to know:
- You can withdraw money from your traditional 401(k) without penalty beginning at age 59½. For Roth 401(k)s you need to reach that age and have had that account for at least 5 years.
- Traditional 401(k) withdrawals are taxed like regular income.
- Roth 401(k)s withdrawals are not taxable because you paid taxes on the money when you deposited it.
- You must start taking at least the required minimum distributions after retirement beginning April 1 of the year after you turn 70½. (If you’re still working this does not apply.)
- If you fail to take the required minimum distribution when you are supposed to, the IRS charges you a penalty of 50% of the amount not distributed.