What is a 401(k)?
A 401(k) plan is a type of qualified employer-sponsored retirement plan that allows employees to save for retirement on a tax-deferred basis. Created after World War II as a part of the Revenue Act of 1978, the 401(k) Plan was intended to attract workers and offer an added benefit to their compensation package. Luckily for us today, the tradition has continued.
The Revenue Act of 1978 introduced a new method that allowed employees to set aside money for their own retirement. This new kind of plan was called a 401(k), named after the section of the Internal Revenue Code (26 U.S.C. § 401), which authorizes the deduction for employee contributions to these plans.
401(k) plans are also known as defined contribution plans, because the employer’s contributions are designated, or “defined,” in advance. The employee’s account balance at retirement depends on how much is contributed to the account and the investment returns earned on those contributions.
Contributions to a 401(k) plan are made on a pre-tax basis, which lowers your taxable income for the year. For example, let’s say you earn $100,000 per year and contribute $10,000 to your 401(k) plan. In this case, you would only report taxable income of $90,000 for the year. This lowers your overall tax bill and allows your retirement savings to grow unimpeded by taxes.
Many employers offer matching contributions, often up to a designated percentage of employee contributions. This means the employer contributes funds to the account equal to a certain percentage of what the employee contributes. The most common matching formula is 50% of employee contributions up to a set amount (e.g., $500 per month).
Employee contributions and investment earnings are tax-deferred until withdrawal, which generally must begin after age 59½. There is no mandatory distribution at any specific age, but 401(k) plan participants must begin taking required minimum distributions (RMDs) from their account by April of the year after they reach age 70½.
Some employers automatically enroll employees in the 401(k) plan, unless they opt-out. Many people are likely to forget to sign up on their own and may miss out on free money from their employer. This can be a great way to save for retirement.
In 2022, employees can contribute up to $20,500 to their plans. This limit is known as the “elective deferral limit.”
Employees aged 50 or older are allowed to make additional “catch-up” contributions of up to $6,500 in 2022. This brings the total annual contribution limit to $27,000.
If you leave your job, you have a few options for your plan:
- You can keep the account with your former employer and continue making contributions.
- You can roll the funds over into an individual retirement account (IRA).
- You can cash out the funds and pay taxes and penalties on the withdrawal.
Which option you choose depends on a variety of factors, including how much money you have in the account and your own personal retirement savings goals.
There are a few common mistakes people make when it comes to their 401(k) plans such as:
- Not contributing enough. Many people do not contribute enough to their 401(k) plans, which can have a negative impact on their retirement savings. To make the most of your plan, you should try to contribute as much as possible up to the annual limit.
- Not diversifying. Investing too heavily in one or two stocks can be risky and may not provide the best return on investment. A well-diversified portfolio that includes a mix of investments is typically more stable and has the potential for higher returns.
- Withdrawing funds prematurely. If you withdraw funds from your plan before age 59½, you will likely incur penalties and taxes on the withdrawal. It is generally best to leave the funds in the account until you reach retirement age.
- Not taking advantage of employer matches. If your employer offers a matching contribution, be sure to contribute enough to receive the full match. This is essentially free money, so why not take advantage? It can go a long way toward boosting your savings for a comfortable retirement.
401(k) case study
Jay is a 45-year-old employee of W Company. They have been with W for ten years and participated in the company’s 401(k) plan since it was established. Jay contributes $200 per month to their account, and their employer matches 50% of their contributions, up to a maximum of $100 per month. Jay’s account has a balance of $100,000, and they expect to retire in 15 years. Jay is considering the following options for their 401(k) account:
- Continue contributing $200 per month to the plan until retirement, with a 50% match from their employer up to $100 per month. This would give them a projected balance of about $520,000 at retirement.
- Increase their contribution to $500 per month, with a 50% match from the employer up to $100 per month. This would give them a projected balance of about $685,000 at retirement.
- Roll over the account into an IRA and invest it in fractional real estate with an average annual return of about 12%. This would give them a projected balance of about $650,000 at retirement.
Based on these options, Jay should consider either contributing more to the 401(k) account or rolling it over into an IRA to maximize their retirement savings.
The bottom line
A 401(k) plan is a retirement savings account that allows employees to save money on a pre-tax basis. Contributions and investment earnings are tax-deferred until withdrawal, which generally must begin after age 59½. There is no mandatory distribution at any specific age, but participants must begin taking required minimum distributions (RMDs) from their account by April of the year after they reach age 70½.
Employees can contribute up to $20,500 per year to their plans, with an additional “catch-up” contribution limit of $6,500 for those 50 or older. If you leave your job, you have a few solid options for your 401(k) plan: You can keep the account with your former employer and continue making contributions; you can roll the funds over into an individual retirement account (IRA), or you can cash out the funds and pay taxes and penalties on the withdrawal.