The Rules of a 401(k) Retirement Plan

How these nest-egg mainstays work, from first deposit to withdrawal

Since its inception in 1978, the 401(k) plan has grown to become the most popular type of employer-sponsored retirement plan in America. Millions of workers depend on the money they invest in these plans to provide for them in their retirement years, and many employers see a 401(k) plan as a key benefit of the job. Few other plans can match the relative flexibility of the 401(k).

Key Takeaways

  • A 401(k) is a qualified retirement plan, which means it is eligible for special tax benefits.
  • You can invest a portion of your salary, up to an annual limit.
  • Your employer may or may not match some part of your contribution.
  • The money will be invested for your retirement, usually in your choice of a variety of mutual funds.
  • You can't usually withdraw any of the money without a tax penalty until you're 59½.

What Is a 401(k) Plan?

A 401(k) plan is a retirement savings account that allows an employee to divert a portion of their salary into long-term investments. The employer may match the employee's contribution up to a limit.

A 401(k) is technically a qualified retirement plan, meaning it is eligible for special tax benefits under Internal Revenue Service (IRS) guidelines. Qualified plans come in two versions. They may be either defined contributions or defined benefits, such as a pension plan. The 401(k) plan is a defined contribution plan.

That means the available balance in the account is determined by the contributions made to the plan and the performance of the investments. The employee must make contributions to it. The employer may choose to match some portion of that contribution or not. The investment earnings in a traditional 401(k) plan are not taxed until the employee withdraws that money. This typically happens after retirement when the account balance is entirely in the hands of the employee.

More than 100 million Americans are covered by defined-contribution plans, like a 401(k) or similar, nearly half of U.S. workers in the private sector. And nearly half of those plans are immediately vested participants in employer matching contributions, according to a 2019 report by Vanguard.

The Roth 401(k) Variation

While not all employers offer it, the Roth 401(k) is an increasingly popular option. This version of the plan requires the employee to immediately pay income tax on the contributions. However, after retirement, the money can be withdrawn with no further taxes due on either the contributions or investment earnings.

Employer contributions can only go into a traditional 401(k) account—not a Roth.

401(k) Contribution Limits

The maximum amount of salary that an employee can defer to a 401(k) plan, whether traditional or Roth, is:

  • $19,500 for 2021
  • $20,500 for 2022

Employees aged 50 and older can make additional catch-up contributions of up to $6,500 in 2021 and 2022.

The maximum joint contribution by both employer and employee is:

  • $58,000 for 2021
  • $61,000 in 2022

People aged 50 and older are allowed to contribute $64,500 in 2021 and $67,500 in 2022.

Limits for High Earners

For most people, the contribution limits on 401(k)s are high enough to allow for adequate levels of income deferral. In 2021, highly paid employees can only use the first $290,000 ($305,000 in 2022) of income when computing the maximum possible contributions.

Employers also can provide non-qualified plans such as deferred compensation or executive bonus plans for these employees.

401(k) Investment Options

A company that offers a 401(k) plan typically offers employees a choice of several investment options. The options are usually managed by a financial services advisory group such as The Vanguard Group or Fidelity Investments.

The employee can choose one or several funds to invest in. Most of the options are mutual funds, and they may include index funds, large-cap and small-cap funds, foreign funds, real estate funds, and bond funds. They usually range from aggressive growth funds to conservative income funds.

Rules for Withdrawing Money

The distribution rules for 401(k) plans differ from those that apply to individual retirement accounts (IRAs). In either case, an early withdrawal of assets from either type of plan will mean income taxes are due, and, with few exceptions, a 10% tax penalty will be levied on those younger than 59½.

But while an IRA withdrawal doesn't require a rationale, a triggering event must be satisfied to receive a payout from a 401(k) plan. The following are the usual triggering events:

  • The employee retires from or leaves the job.
  • The employee dies or is disabled.
  • The employee reaches age 59½.
  • The employee experiences a specific hardship as defined under the plan.
  • The plan is terminated.

Post-Retirement Rules

The IRS mandates 401(k) account owners to begin what it calls required minimum distributions (RMDs) at age 72 unless that employer still employs the person. This differs from other types of retirement accounts. Even if you're employed, you have to take the RMD from a traditional IRA, for example.

Money withdrawn from a 401(k) is usually taxed as ordinary income.

Following the passage of the Setting Every Community Up For Retirement Enhancement (SECURE) Act in December 2019, the age for RMDs was raised from 70½ to 72.

The Rollover Option

Many retirees transfer the balance of their 401(k) plans to a traditional IRA or a Roth IRA. This rollover allows them to escape the limited investment choices that are often present in 401(k) accounts.

If you decide to do a rollover, make sure you do it right. In a direct rollover, the money goes straight from the old account to the new account, and there are no tax implications. In an indirect rollover, the money is sent to you first, and you will owe the full income taxes on the balance in that tax year.

If your 401(k) plan has employer stock in it, you are eligible to take advantage of the net unrealized appreciation (NUA) rule and receive capital gains treatment on the earnings. That will lower your tax bill significantly.

To avoid penalties and taxes, a rollover must take place within 60 days of withdrawing funds from the original account.

401(k) Plan Loans

If your employer permits it, you may be able to take a loan from your 401(k) plan. If this option is allowed, up to 50% of the vested balance can be borrowed up to a limit of $50,000. The borrower must repay the loan within five years. A longer repayment period is allowed for a primary home purchase.

In most cases, the interest paid will be less than the cost of paying real interest on a bank or consumer loan—and you will be paying it to yourself. But be aware that any unpaid balance will be considered a distribution and taxed and penalized accordingly.

Hardship Distributions

There may come a time when emergencies arise. And you may find that the only place you can turn to meet your immediate financial needs is your retirement plan. While it may not necessarily be the best route, you have the option to take hardship distributions or withdrawals. There are a number of considerations when it comes to this kind of withdrawal:

  • There must be a clear and present need to take a hardship distribution. It can also be a voluntary or foreseeable need as long as it is reasonable.
  • The amount of the withdrawal must not exceed the need.
  • You can't take any elective distributions for six months after the hardship withdrawal.

This type of withdrawal is taxable. And if you take one of these, you aren't expected to pay it back to the account. Full details on hardship distributions are available through the IRS website.

How Do I Start a 401(k)?

A 401(k) plan is only offered through an employer, which means you can't start investing in one on your own. If your employer does offer this type of retirement plan, you must sign up and figure out how much you wish to contribute. This is the amount that will be deducted from each paycheck. Be sure that this amount doesn't put you over the contribution limit set by the IRS. Your employer may also offer investment options, such as mutual funds, from which to choose. Your contributions will be divided between these funds as per your allocation instructions.

What Benefits Does a Traditional 401(k) Plan Offer?

There are a number of benefits that traditional 401(k) plans offer investors. Making payroll contributions means it's a no-fuss, no-muss process. These plans allow you to contribute pre-tax dollars for retirement, which lowers your taxable income and, therefore, your tax liability. If your employer provides a contribution match, it sweetens the pot. That's because it's like free money going into your retirement pocket. If you start investing earlier, your savings compound. This means that any interest your earn also earns interest. And even if you change employers/jobs, you can take it with you.

What's the Difference Between a Traditional 401(k) and a Roth 401(k)?

While traditional 401(k) plans allow you to make pre-tax contributions, the Roth version involves after-tax contributions. The tax benefit, though, occurs when you make withdrawals from your account. When you take required minimum distributions from a Roth 401(k), that money is tax-free. Withdrawals from traditional accounts, though, are taxed at your normal tax rate. That's because the contributions are made on a tax-free basis.

The Bottom Line

Saving for retirement should be on everyone's radar, especially if you want to maintain the same lifestyle you currently have. But with so many options, where do you start? The best place is the 401(k) plan, which is offered by employers. If your company has this plan, take advantage of it. This is even more important if your employer matches contributions. But it isn't just about socking away the money that counts. Knowing the ins and outs and the rules associated with the plan can make you a better investor.

Article Sources
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