The Basics of an Employer-Sponsored 401(K) Plan
Section 401(k) was added to the Internal Revenue Code due to the Revenue Act of 1978. A 401(k) is a type of defined contribution retirement plan sponsored by an employer. Several types of 401(k) plans exist, such as a SIMPLE 401(k), Roth 401(k), or Safe Harbor 401(k), but for this article, I will discuss contributions to a pre-tax, Traditional 401(k).
If you participate in your employer’s 401(k) plan, you may elect to have a portion of your salary contributed to the 401(k) on a pre-tax basis. Although the amount contributed is not reflected as taxable income on your tax return, the contributions are not tax-free but are merely tax-deferred.
Thus, income tax is due when the funds are withdrawn or distributed.
401(k) plans vary, and your employer may also have policies relating to the 401(k) plan, such as a waiting period (e.g., six months after your employment start date) before you can begin contributing. Any matching formula and vesting requirement, as discussed below, will vary. Ask your firm’s human resources representative or a managing partner any questions you have about your employer-sponsored 401(k) plan.
Although your employer sponsors the 401(k) plan, a brokerage firm or investment company usually administers the plan. You are responsible for choosing how to invest in the 401(k) plan among the options offered. A financial advisor can advise you regarding which investments to select. Once the money is invested into your 401(k) plan, in addition to the income tax due, any withdrawals before you turn 59½ years old will be subject to a 10 percent penalty.
401(k) accounts are also subject to yearly contribution limits. In 2021, annual contributions to 401(k)s are capped at $19,500.00 (the cap gets slightly higher when you turn 50). The combined contribution of both an employer and employee is also limited and, in 2021, cannot exceed $58,000 or 100 percent of the employee’s compensation.
Now that you are familiar with the basics of how a 401(k) account functions, let’s explore the advantages of participating in a 401(k).
Advantages of Using a 401(K)
A significant advantage of using a 401(k) is that contributions are taken out of your paycheck before federal income taxes are withheld, resulting in a lower total taxable income and possibly even lowering your applicable tax bracket. When distributions are made during retirement or while you are still working, the deferred income taxes become due after you turn 59½ years old. The general concept is that you may be in a lower income tax bracket during retirement than during your later working years, resulting in less income tax being owed on distributions.
Employers will frequently offer to match your 401(k) contributions up to a certain amount as an incentive. For example, your employer may offer a 5 percent match if you contribute 5 percent of your salary to your 401(k). To illustrate, if your salary is $90,000 per year, you are paid every month ($7,500 per month pre-tax), and you contribute the minimum 5 percent of your salary to get your employer’s 5-percent match, your contribution is $375.00 per month, and your employer’s contribution is $375.00 per month, totaling $750.00 per month or $9,000.00 per year. Alternatively, employers may choose to match a specific dollar amount. For example, perhaps you must contribute $2,500 per year to get the employer match of $2,500 per year, totaling $5,000 per year.
Damon Baruth, a financial analyst with Primerica located in Sioux Falls, South Dakota, put it this way: “Employees are essentially giving themselves a 5-percent pay raise if they are contributing to a 401(k) and getting the employer match of 5 percent.” If you choose not to take advantage of your employer-sponsored 401(k) plan or do not contribute enough to get the employer match, then any applicable amount that could have been contributed and the corresponding match for that year is lost. If instead, you decide to save aggressively and “max-out” your 401(k) contributions or save some additional amount above your employer’s match, understand that any amount you contribute above your employer’s match is not eligible for additional matching by your employer.
The employer match may also be subject to vesting requirements, which vary among 401(k) plans. Once the employer’s contributions are 100 percent vested, you own them. However, before vesting, if you leave employment, you may forfeit any non-vested contributions made by your employer.
Beginning to save for retirement early allows your money to grow for a more extended period. The longer the investment is set aside, the longer interest is compounding and taking advantage of the markets. Although the markets fluctuate, taking into account recessions and downturns, they generally increase over time.
Saving for retirement by starting with a 401(k) is a great first step. Baruth would also strongly encourage young professionals to “get a personal retirement account, such as a Roth IRA, [because] it is a great way to have your money grow while invested in the markets and puts your money to work for you.”
However, there are many different retirement savings options besides an employer-sponsored 401(k). The below is an overview of a few other options for retirement savings and how those products compare to a 401(k) account.
Comparing a 401(K) to Other Investment Accounts
Another option to save for retirement is by contributing to a Traditional IRA. The term “IRA” stands for Individual Retirement Account. Traditional IRAs provide more choices for investing than a 401(k) plan and are generally funded with pre-tax income. The contributions are not counted as income on your tax return, and the contributions grow tax-deferred. You will pay tax when you withdraw the money. In 2021, the annual contribution limits for Traditional IRAs are $6,000 (with a little higher cap if you’re 50 or older). Withdrawals can begin at 59½ years old, but early withdrawals are subject to penalty.
A Roth IRA is another popular way for employees to save. A Roth IRA differs from a 401(k) in many ways, principally in how it is taxed. Contributions to a Roth IRA are not tax-deferred but instead are made with after-tax dollars. This means that when funds are withdrawn, the withdrawals are tax-free because the tax has already been paid. Contributing to a Roth IRA may be beneficial if you anticipate being in a higher income tax bracket during your retirement years or if you anticipate a generally higher tax rate during retirement.
In 2021, annual contribution limits to a Roth IRA are capped at $6,000 (with a little higher cap if you’re 50 or older). You can contribute to a Roth IRA at any age as long as the account owner has earned income and can be maintained indefinitely. The account must be opened for at least five years before you can make tax- and penalty-free withdrawals. Unlike a 401(k) or a traditional IRA, there are no required minimum distributions (RMDs) during the account holder’s lifetime—meaning you aren’t required to start withdrawing at a particular age.
Taxable Brokerage Account
Finally, a taxable brokerage account is flexible and may be an attractive savings vehicle if you have already maxed out contributions to other retirement savings options. Unlike a 401(k), there are no income limits, contributions limits, or RMDs. Furthermore, withdrawals can be made anytime and for any purpose without a penalty. You will still choose what investments to make based on availability at the institution where the account was opened.
A taxable brokerage account is funded with after-tax dollars, and there is no tax incentive for contributing. The account is also subject to annual tax for dividends, interest, or capital gains distributions received during that year.
Ensuring you can live comfortably after retirement is incredibly important. It’s never too early to start saving.