Retirement-Plan-(401k)

What is a 401(k) Plan?

This is a retirement plan where employees can contribute from their paychecks. A 401(k) plan is a defined-contribution retirement account offered by employers to their employees. Employees can make contributions to their 401(k) accounts through automatic payroll withholding, and their employers can match some or all of those contributions.

There are mainly two types of 401k plans:-Traditional 401(k) & Roth 401(k) sometimes referred to as a "designated Roth account." The two are similar in many aspects, but they taxed differently. An employee can have either type of account or both.

 

KEY TAKE AWAYS

• A 401(k) plan is a retirement account sponsored by employer that employees can contribute to. Employers may also make matching contributions.
• There are two 401k plans which mainly used - traditional and Roth—which differ primarily in how they're taxed.
• Traditional 401(k), employee contributions reduce their taxable wages and income taxes for the year they are made, but their withdrawals are taxed. With a Roth, employees make contributions with post-tax income but can make withdrawals tax-free.
• For 2020, under the CARES Act, withdrawal rules and amounts were relaxed for those affected by COVID-19, and RMDs were suspended.

 

Contribution Limits

The maximum amount that an employee or employer can contribute to a 401(k) plan in a year is adjusted periodically to account for inflation. As of 2020 and in 2021, the basic limits on employee contributions are $19,500 per year for employees under age 50 and $26,000 for those 50 and above (including the $6,500 catch-up contribution).

If the employer also contributes—or if the employee elects to make additional, non-deductible after-tax contributions to their traditional 401(k) account (if allowed by their plan)—the total employee/employer contribution for workers under 50 for 2021 is capped at $58,000, or 100% of employee compensation, whichever is lower. For those 50 and over, again for 2021, the limit is $64,500.

 

Employer Matching

Employers who match their employee contributions use different formulas to calculate that match. A common example might be 50 cents or $1 for every dollar the employee contributes up to a certain percentage of salary. Financial advisors often recommend that employees try to contribute at least enough money to their 401(k) plans each to get the full employer match.

 

Contributing to a Traditional and Roth 401(k)

If they wish—and if their employer offers both choices—employees can split their contributions, putting some money into a traditional 401(k) and some into a Roth 401(k). However, their total contribution to the two types of accounts can't exceed the limit for one account (such as $19,500 (if you are under age 50) in 2020 and 2021).

Employer contributions can only go into a traditional 401(k) account—not a Roth—where they will be subject to tax upon withdrawal.

 

Taking Withdrawals from a 401(k)

Participants should remember that once their money is in a 401(k), it may be hard to withdraw without penalty.

"Make sure that you still save enough on the outside for emergencies and expenses you may have before retirement," says Dan Stewart, CFA®, president of Revere Asset Management Inc., in Dallas, Texas. "Do not put all of your savings into your 401(k) where you cannot easily access it, if necessary."

The earnings in a 401(k) account are tax-deferred in the case of traditional 401(k)s and tax-free in the case of Roths. When the owner of a traditional 401(k) makes withdrawals, that money (which has never been taxed) will be taxed as ordinary income. Roth account owners (who have already paid income tax on the money they contributed to the plan) will owe no tax on their withdrawals, as long as they satisfy certain requirements.

Both traditional and Roth 401(k) owners must be at least age 59½—or meet other criteria spelled out by the IRS, such as being totally and permanently disabled—when they start to make withdrawals. Otherwise, they usually will face an additional 10% early-distribution penalty tax on top of any other tax they owe.

 

Special Changes in 2020

The $2 trillion corona virus emergency stimulus bill that was signed into law on March 27, allows those affected by the corona virus pandemic a hardship distribution up to $100,000 without the 10% early distribution penalty those younger than 59½ normally owe. Account owners also have three years to pay the tax owed on withdrawals, instead of owing it to the IRS in the current year.6

This hardship provision must be adopted by the plan so it’s best to check with your plan administrator first, or they can repay the withdrawal to a 401(k) or IRA and avoid owing any tax—even if the amount exceeds the annual contribution limit for that type of account.

 

Traditional 401(k) vs. Roth 401(k)

When 401(k) plans first came in existence in 1978, companies and their employees had just one choice: the traditional 401(k). Then, in 2006, Roth 401(k)s arrived. Roths are named for former U.S. Senator William Roth of Delaware, the primary sponsor of the 1997 legislation that made the Roth IRA possible.

While Roth 401(k)s were a little slow to catch on, many employers now offer them. So the first decision employees often have to make is between Roth and traditional.

As a general rule, employees who expect to be in a lower marginal tax bracket after they retire might want to opt for a traditional 401(k) and take advantage of the immediate tax break. On the other hand, employees who expect to be in a higher bracket might opt for the Roth so that they can avoid taxes later. For example, a Roth might be the right choice for a younger worker whose salary is relatively low now but likely to rise substantially over time.

Also important—especially if the Roth has years to grow—is that there is no tax on withdrawals, which means that all the money the contributions earn over decades of being in the account is also not taxed.

Since no one can predict what tax rates will be decades from now, neither type of 401(k) is a sure thing. For that reason many financial advisors suggest that people hedge their bets, putting some of their money into each.

401k type	Tax rules	Withdrawal rules
Traditional	Wages are contributed before taxes from each paycheck, like a deferred salary. Taxable income drops by the amount you contribute. You pay income taxes on contributions and earnings upon withdrawal.	No access to your funds before age 59 ½ or if you leave your employer at age 55 or older. If you dip in early, expect a 10% penalty — on top of the usual tax bill.
Roth	Contributions are made with money that’s already been taxed. No taxes paid upon withdrawal.	Better flexibility: free access to your money as long as you’ve held the account for 5 years.