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Retirement Basics: Understanding a 401(k) Plan
April 30, 2022
A 401(k) plan is a tax-advantaged retirement savings plan that is offered by many American employers. The term “401(k)” is derived from the Internal Revenue Code clause that oversees the programs.
When an employee enrolls in a 401(k), he or she agrees to have a portion of each paycheck deposited directly into an investing account. A part of your payments may potentially be matched by your employer. Your savings are invested in the stock market and increase over time, providing you with a source of income in retirement.
How Do 401(k) Plans Work?
The United States Congress created the 401(k) plan to encourage Americans to save for retirement. There are two basic choices, each with its own set of tax benefits.
Traditional 401(k)
Traditional 401(k) contributions are deducted from your paycheck before taxes are computed. This implies that contributions directly reduce your taxable income. The money is put into mutual funds and other assets, and it grows in value over time. Withdrawing funds from a traditional 401(k) in retirement is subject to ordinary income tax.
Roth 401(k)
Contributions to a Roth 401(k) are taken from your after-tax income, which means they do not lower your taxable income. There are no additional taxes required on the employee’s contribution or the investment earnings when the money is taken at retirement.
If you feel you will be in a higher tax rate when you retire than you are now, going for a Roth 401(k) is a logical choice. Lower income levels and tax rates may make a Roth 401(k) an attractive option for many young workers just starting their careers.
Unfortunately, Roth accounts are not available at all companies. If the Roth is available, the employee can choose one or the other, or a combination of the two, up to the yearly tax-deductible contribution limitations.
Contributing to a 401(k) Plan
Annually, you determine how much of your salary to contribute into a 401(k) plan, subject to IRS limitations. When you start a new job, you usually choose to save a percentage of your yearly income in your employer’s 401(k), and you may alter your contribution as often as the plan’s regulations allow. You have the option to stop making contributions at any time and for any reason.
Employees will select the particular investments for their 401(k) accounts from a menu of options provided by their company. Typically, these programs contain a mix of stock and bond mutual funds, as well as target-date funds designed to decrease the risk of investment losses as the person approaches retirement.
401(k) Contribution Limits
The maximum amount that an individual or company may contribute to a 401(k) plan is modified on a regular basis to compensate for inflation, which is a measure of growing costs in an economy.
Employee contributions are limited to $19,500 per year for workers under the age of 50 in 2021, and $20,500 per year in 2022. Those aged 50 and older, on the other hand, can make a $6,500 catch-up payment in 2021 and 2022. Thus, the total combined contribution for 2021 is $26,000 and $27,000 for the current year 2022. These restrictions apply to all 401(k) contributions, regardless of whether they are split between pre-tax and Roth contributions, or if you work for two companies in a year and so have two distinct 401(k) accounts.
Several employers also permit non-Roth donations made after taxes. A combined employee and employer contribution maximum applies in such instances. In other words, the total of your employer’s contributions plus your pre-tax, Roth, and after-tax contributions cannot exceed this amount.
The combined maximum for 2021 is $58,000, or $64,500 for individuals 50 and over. The total limit increases to $61,000 or $67,500 for individuals 50 and older in 2022.
What is 401(k) Employer Matching?
Some companies match their workers’ 401(k) contributions up to a particular percentage of salary. Employers who match their employees’ contributions utilize a variety of formulae to do so. An employer may, for example, match 50 cents for every dollar an employee puts in up to a particular percentage of compensation. Another method is where a company matches employee contributions dollar-for-dollar up to a total of 3% of their salary.
Taking Withdrawals from a 401(k) Account
The funds you put into a 401(k) is supposed to provide you with income in retirement. Until you reach the age of 59 1/2, IRS restrictions bar you from taking money from a 401(k) without penalty. With some exemptions, early withdrawals from a traditional 401(k) are liable to a penalty fee of 10% of the amount taken, as well as an obligatory income tax withholding of 20% of the amount withdrawn.
Required Minimum Distribution (RMD)
RMDs, or required minimum distributions, are required for traditional 401(k) account holders once they reach a specific age. (In IRS jargon, withdrawals are referred to as “distributions.”)
RMDs are needed for both traditional and Roth 401(k) account holders at the age of 72. The amount of your RMDs is determined by your age and account balance. You can withdraw as much as you like from the account annually, either in one large payment or in a succession of periodic withdrawals, as the name implies. RMDs from a traditional 401(k) are included in your taxable income, while RMDs from Roth 401(k)s are not.
How to Avoid 401(k) Early Withdrawal Penalties
If you are under the age of 59 12, there are certain circumstances that enable you to take premature withdrawals from your 401(k) and avoid the 10% early withdrawal tax penalty. Here are a few examples:
- Medical bills that total more than 10% of your adjusted gross income
- Incapacity for life
- Military service in some cases
- If you quit your job at the age of 55 or older,
- A “Qualified Domestic Retirement Order,” which is granted as part of a divorce or a court-ordered separation.
401(k) Loans
Several 401(k) program allows you to take out loans against your funds, known as a 401(k) loan. You can take out a loan for up to $50,000 or 50% of your vested amount, whichever is lower. You’ll be charged interest and origination costs if you don’t pay back the loan within five years, but the interest will go back into your 401(k).
If you don’t repay the loan within five years, the IRS deems it a distribution, and you’ll have to pay taxes and a 10% penalty. If you quit or lose your work, the plan sponsor may compel you to refund the unpaid sum promptly, and if you don’t, the sponsor may record it as a distribution to the IRS. Nevertheless, you have until October of the following year–the deadline of your tax return with extensions–to deposit the loan balance in an IRA and avoid paying any taxes or penalties right away.
Disclaimer
- The information provided is for educational purposes only and does not constitute personal financial, tax or investment advice and should not be relied on as such. It does not take into consideration any investor’s particular investment objectives, strategies, time horizon, and tax or legal status. Abacus Wealth International (AWI) does not provide tax or legal advice. Please consult a tax or legal professional for corresponding tax and legal advice.
- All material and content have been obtained from sources believed to be reliable. AWI does not guarantee the accuracy of the information provided and shall not be held liable for decisions based on the foregoing information.
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