What is 401k?
A 401k plan is a type of retirement account offered by US employers wherein employees contribute through monthly or quarterly salary deductions matched by employers.
The employees contribute to investments based on their personal preferences and the employer’s choice of investments. These investments can be exchange-traded funds (ETFs) and mutual funds that will earn tax-deferred income.
A 401k plan is one of the most popular retirement investment options. It was established in 1978.
Why is it called 401k?
It is called 401k because it is named after the Internal Revenue Code (IRC) section 401k, which allows tax-free contributions until the account holder starts withdrawing funds during retirement.
Is a 401k plan compulsory?
A 401k plan is not compulsory, on the employer’s or employee’s side. Employers are not mandated to provide a retirement plan for their employees, except in some states requiring them to do so. However, most companies offer 401k plans as an employee benefit to attract employees and encourage them to stay in the company and also for tax credits.
Some companies implement 401k auto-enrolment, an option legalized by the Pension Protection Act of President George W. Bush, signed in 2006. This act allows companies to enroll their employees in a retirement plan without their permission. An employee can opt out of a 401k plan after being auto-enrolled.
What are 401k Companies?
Employers need a 401k company to handle the employees’ 401k plans' investments and administration. These 401k companies charge for services differently and also have different investment rosters. The 401k companies also offer 401k training for employees to give them a better understanding of how the plan earns through the investments.
Some of the best 401k companies are:
Employees decide on the percentage of salary deducted as 401k contributions. Employers will also contribute a share to the 401)k) plan from their determined contribution. An employer's most common contribution is 6% of the employee’s salary.
401k loans can be taken out in the amount of $50,000 or 50% of the account balance, whichever is less, tax-free. The loan is paid off with a small interest that is lower than usual bank loan rates to cover for lost earnings that the loan amount may have earned if it wasn’t withdrawn for a loan. These loan payments are also salary-deducted.
401k Pros and Cons
- 401k matching - Employee contribution is matched by the employer, usually averaging 6% of an employee’s total salary. A 401k match is as good as free money added to an employee's 401k retirement plan.
- High contribution limits - With the highest contribution limits of any retirement plan, a 401k plan allows contributions to total $22,500 annually, as of 2023.
- Loan options - Employees can loan up to an equivalent of 50% or $50,000, (whichever is less) with up to five years to repay the loan fully.
- Tax advantages - 401k contributions may be tax-deferred for traditional accounts or withdrawn tax-free for Roth accounts.
- Safety from Creditors - 401k plans are set up under the Employee Retirement Income Security Act (ERISA), which protects them against creditors.
- No control over accounts -Employee contributions get deducted regardless of how the investments or the stock market perform. Employees choose investments based only on a list given to them.
- Tax penalties for early withdrawals - If you withdraw money before the age of 59 ½, your withdrawals will incur a 10% tax penalty, in addition to paying ordinary income tax on the withdrawn amount.
- High fees - 401k companies may charge high fees for their administration services. These fees are usually incorporated into the mutual fund expenses though some reflect the fees separately.
Types of 401k Investments
The usual investments made on a 401k are:
- Mutual funds - a collection of assets that invest in bonds, stocks and securities
- ETFs (Exchange-Traded Fund) - Similar to a mutual fund but can be purchased or sold in the stock market like a regular stock.
- Company Stock - This investment is in publicly traded companies, which could be the company the employee works for.
- Variable annuities - a form of insurance product that combines the features of a mutual fund and insurance.
- Stocks, bonds, and other securities - Some 401k plans allow the purchase of various securities through a 401k brokerage account. This may incur transaction costs and brokerage commissions.
Types of 401k Plans
Employers can choose from these types of 401k plans:
1. Traditional 401k plans
In a traditional 401k plan, qualified employees can make pre-tax elective deferrals* via payroll deductions. Employee contributions and investment earnings under a traditional 401k plan are tax-deferred until the investment is withdrawn. Employers have the option to contribute, matching their contributions based on employees’ elective deferrals.
*Elective deferrals are deductions allowed by an employee to be transferred to a retirement plan. Elective deferral contributions are excluded from employees' gross income unless their retirement plan is a Roth 401k.
2. Safe Harbor 401k plans
In a Safe Harbor 401k plan, all qualified 401k plan holders are entitled to an employer contribution. These employer contributions allow the employer to skip the annual Internal Revenue Service (IRS) nondiscrimination testing.
The IRS nondiscrimination testing ensures that the retirement plan is fair for all eligible employees, including lower-earning workers.
3. SIMPLE 401k plans
A SIMPLE 401k plan is like a traditional 401k plan but designed for businesses with less than 100 employees. SIMPLE 401k plans have smaller contribution amounts and require employers’ contributions.
4. Roth 401k plans
In a Roth 401k plan, contributions are paid with after-tax income. Withdrawals after the age of 59 ½ are tax free.
How does a 401k plan work?
A 401k plan begins as an employee starts employment with a company. During onboarding, the employer provides all the forms and takes care of processing the 401k account. Contributions are then deducted from the employee’s salary on a monthly or quarterly basis.
What is 401k max contribution limit for 2022 and 2023?
The 401k maximum contribution limit for 2022 and 2023 are $20,500 and $22,500, respectively, per employee. These contribution limits include all salary deferrals and after-tax contributions to a Roth 401k plan.
Employees can take money out of their 401k plan through a 401k withdrawal. A withdrawal can be for an emergency expense, another investment account, or additional funds for any necessary expenditures.
Employees pay taxes on a 401k withdrawal if the funds are withdrawn before the age of 59 ½. The withdrawn amount will be lumped together with the total taxable income for the year and will be charged income tax, on top of being charged a 10% tax penalty for early withdrawals. However, there are exemptions from the tax penalty that is also applied to early IRA withdrawals.
When an employee quits, the 401k funds can remain with the employee through these methods
- Rollover 401k funds into a new plan - If the new job offers a 401k plan, the employee can secure the 401k funds from the previous job through a rollover transaction to transfer these funds to the new 401k account.
- Rollover 401k plan into an IRA - A rollover of the funds from the former 401k account can be done to fund an IRA.
- Take out distribution if aged over 59 ½ - If an employee leaves a job and is already aged 59 ½, withdrawal of 401k funds is possible with no tax penalty.
- Cash out - Cashing out or withdrawing 401k funds upon quitting a job is possible but will incur a tax penalty.
Upon reaching the age of 72 (or 73 if the birthday was December 31 of the previous year), withdrawals from 401k plans become mandatory and are also known as required minimum distributions (RMD).
A 401k plan pays monthly or quarterly, depending on which RMD frequency the employee chooses. The distribution amount can be changed once a year.
RMDs are still required for Roth 401k plans for 2023 but shall be exempted from 2024 onwards.
What is a 401k Hardship Withdrawal?
A hardship withdrawal is a distribution from a 401k plan due to an urgent financial need. The hardship withdrawal limit is also $50,000. It is different from a 401k loan because the withdrawn amount is taxed and is not returned to the borrower’s account.
Employees who have taken a hardship withdrawal aged 30-50 years old can get their 401k back on track by getting an additional 1% of their salary deducted to boost their 401k plan.
How does 401k make money?
A 401k makes money by growing the employee’s and employer’s matching contributions, through investments of the 401k funds. These funds accumulate compounding interest tax-free.
Why invest in a 401k instead of investing directly?
Invest in a 401k instead of investing directly because of the tax benefits. Also, investing directly is more for short-term investments while a 401k plan is investing for retirement, which is more of a long-term investment. A 401k plan also allows loans or hardship withdrawals in case of urgent needs.
IRA vs. 401k Plans
An individual retirement plan is another type of retirement investment that allows an individual more control over the investment account while still enjoying tax privileges. Here are the features of 401k plans vs. IRAs.
Annual Contribution Limit
- Employee's Salary Deduction
- Employer's Contribution
- Rollover from other investment accoutns
- Selected by account holder
- Wider selection of investments
- Includes physical precious metal investment
- Option to loan against funds
- No loan options
Annual Contribution Limit
- $22,500 per employee below 50 years old
- $30,000 per employee above 50 years old
- $66,000 combined limit for employer and employee below 50 years old
- $6500 for account holders below 50 for 2023
- $7500 for account holders above 50
The 401k plan is the most favored retirement investment plan offered by companies as a perk for employees to join and stay in their organization. The most attractive feature of a 401k plan is the employer’s matching contribution, which gives employees additional funds in their retirement plan for free.
Different kinds of 401k plans give employers a chance to make the most out of their budgets for employees, depending on the company size. There is also a wide range of 401k companies that can help with the management of investments and administration of 401k plans.