A 401(k) plan is a retirement saving account given to you by your employer to divert a portion of their salary into long-term investments. It’s a special type of account funded through pre-tax payroll deductions. The funds in the account can be invested in a number of different stocks, bonds, mutual funds, or other assets, and are not taxed on any capital gains, dividends, or interest until they are withdrawn.
A 401(k) is a “qualified” retirement plan. That means it is eligible for special tax benefits under IRS guidelines, meaning the plans may be either defined-contribution or defined-benefit. For more information, you can check out Investopedia’s articles on defined-contribution or defined-benefit plans.
The Benefits of a 401(k) retirement plan are (1) tax advantages, (2) employer match programs, (3) investment customization and flexibility, (4) loan and hardship withdrawals, and (5) moving the account to another employer.
Here are some websites to give you more information:
The Balance’s “Understanding Your 401(k) Retirement Plan”
Investopedia’s “401(k) Plans: The Complete Guide”
Investopedia’s “The Basics of a 401(k) Retirement Plan”
Nerdwallet’s “What Is a 401(k)?”
You have to decide whether or not you want to participate in the 401k, and how much you will contribute each pay period. If you earn $750 each pay period and elect to defer 5% of your pay, $37.50 is taken out of your pay and placed in the 401k plan. These contributions are deducted from your salary on a pre-tax basis. This means that by contributing to a 401k, you actually lower the amount you pay in current income taxes. For example, instead of being taxed on the full $750 per pay period, you are only taxed on $712.50 ($750 minus your 401k contribution of $37.50 equals $712.50). You don’t owe income taxes on the money contributed until you withdraw it from the plan.
Salary-deferral plans are generally self-directed. This means you are responsible for deciding how to invest the money that accumulates in your account. Usually, you must choose among a list of investments the plan offers. The advantage of self-direction is that you can select investments that you believe will help you achieve your long-term goals. But, of course, it also means added responsibility for choosing wisely.
When you participate in a traditional 401(k) plan, the taxable salary that your employer reports to the IRS is reduced by the amount that you defer to your account. This means income taxes on that money are postponed until you withdraw from your account, usually after you retire.
If you participate in a Roth 401(k), the amount you defer doesn’t reduce your taxable income or your current income taxes. But when you withdraw after you retire, the amounts you take out are tax-free, provided you’re at least 59½ and your account has been open at least five years .
Participating in a 401(k) plan gives you a head start on your long-term financial security. A 401(k) not only provides a mechanism for saving. It also allows the money in your account to compound tax-deferred. That means that the earlier you begin to participate and the more you contribute, the greater chance you’ll have of amassing a substantial retirement account.
You can also check out Nerdwallet’s 401(k) Calculator to see how your savings will grow over time.
The federal government caps the amount you can contribute to your account each year. See the Annual Contribution Limits Table for current caps, which can change from year to year. You are also responsible for the investment results you achieve, though your employer has the obligation to offer appropriate investment alternatives.
Generally, a 401k participant may begin to withdraw money from his or her plan after reaching the age of 59½ without penalty. The Internal Revenue Code imposes severe restrictions on withdrawals of tax-deferred or Roth contributions while a person remains in service with the company and is under the age of 59½. Any withdrawal that is permitted before the age of 59½ is subject to an excise tax equal to ten percent of the amount distributed (on top of the ordinary income tax that has to be paid), including withdrawals to pay expenses due to a hardship.
The Internal Revenue Code generally defines a hardship as any of the following:
(1)Unreimbursed medical expenses for the participant, the participant’s spouse, or the participant’s dependent.
(2) Purchase of principal residence for the participant.
(3) Payment of college tuition and related educational costs such as room and board for the next 12 months for the participant, the participant’s spouse or dependents, or children who are no longer dependents.
(4) Payments necessary to prevent foreclosure or eviction from the participant’s principal residence.
(5) Funeral and burial expenses.
(6) Repairs to damage of participant’s principal residence.
Some employers may disallow one, several, or all of the previous hardship causes. To maintain the tax advantage for income deferred into a 401(k), the law stipulates the restriction that unless an exception applies, money must be kept in the plan or an equivalent tax-deferred plan until the employee reaches 59 years of age.
Due to COVID-19, there have been changes made in 2020. The CARES Act that was signed into law on March 27, allows those affected by the coronavirus 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 in the current year. Note this 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.