What Is a 401(k) Plan?

A 401(k) – and its more selective variants, 403(b)s and 457(b)s – are defined contribution plans to help you save for your retirement.

🤔 Understanding 401(k) plans

There are a few different types of retirement plans out there that you can choose.

401(k)s – and their more selective variants 403(b)s and 457(b)s –  are tax-advantaged, which means that they have special tax benefits or deferral options.

Because 401(k)s are employer-sponsored accounts, both the employer and employee can contribute funds. The IRS caps the exact dollar amount, with the amount changing yearly to account for inflation.

In 2020, the IRS set annual employee contribution limits at:

• $19,500 for workers under 50
• $26,000 for workers over 50

For combined employee-employer contributions, or for employees who invest beyond the maximum tax deduction, the IRS set the limit at $57,000 (or $63,500 over 50). While the government does not require employers to match contributions, many include 401(k) matching in their employee benefits package.

With any type of 401(k), it’s still up to the employees to select specific investments under their plan. However, the sponsoring company handpicks these investments first, which can limit your options. Most companies offer an assortment of securities, such as mutual funds, target-date funds, and even company stock in their benefits packages.

Traditional vs Roth 401(k)s

There are two main types of 401(k)s: traditional and Roth accounts. The primary difference between these retirement funds has to do with taxes.

With a traditional 401(k), an employee deposits pre-tax funds into the account. The employee can then write this amount off on their tax return, which lowers their adjusted gross income for the year and may even push them into a lower tax bracket.

However, when it comes time to take a withdrawal, the government levies income taxes at the employee’s current tax bracket on every paycheck. This income tax also applies to any interest earned in the account.

On the other hand, employees who use a Roth 401(k) deposit funds post-tax, which means that qualified withdrawals – and the interest earned on the account – come out tax-free come retirement. However, because the individual pays taxes before contributing toward the account, these funds can’t be written off on a tax return.

An employee may utilize both types of accounts to capitalize on their benefits. However, only employees may contribute to a Roth 401(k), whereas employers can also contribute to a traditional 401(k). Furthermore, contributions to both accounts cannot exceed the annual limit set by the IRS. (As a reminder, that amount is $19,500 in 2020).

Withdrawals

Withdrawal requirements for 401(k)s are fairly strict to ensure the money stays put until you need it (and the federal government gets their cut). Those who don’t meet special criteria – such as a permanent disability – will be charged a 10% early-withdrawal penalty on top of applicable taxes for removing funds before the age of 59½. 

Furthermore, both traditional and Roth 401(k)s have RMDs, or required minimum distributions. This means that, beginning at age 72 (as of 2020), the account holder must take out a minimum payment from their 401(k), whether or not they need or want the money.

Individuals who still work for the company holding their 401(k) are exempt from RMDs. Additionally, you can avoid RMDs by rolling your account into a Roth IRA, although there are restrictions, fees, and legal concerns that come with this move.

What this means for you

Generally speaking, a Roth 401(k) is best for workers who expect to be in a higher tax bracket come retirement. This allows individuals to avoid paying higher income taxes on withdrawals. Young workers and those making their way up a corporate ladder fall into this category.

Conversely, those who may be in a lower tax bracket come retirement may see more benefits from a traditional 401(k). This allows them to take a tax break on their income now and pay lower income taxes on withdrawals later.

It’s also worth noting that 401(k) contributions are invested into various funds to grow, but the interest earned and withdrawn in a Roth won’t be taxed. However, with a traditional 401(k) account, any interest on invested funds is subject to the same income tax as the original contributions. This means that investing in a Roth 401(k) at a young age can be more valuable over time than investing in solely a traditional 401(k).‍