401(k) Retirement Plan Basics
A 401(k) plan is a type of defined contribution plan that enables employees to make pre-tax contributions to a retirement account. A traditional 401(k) offers a tax deduction upon contributing money. Once deposited, the money has the opportunity to grow tax-deferred until the point of withdrawal — ideally, this happens in retirement.
Employers may also choose to match their employees’ contributions, further boosting their retirement savings. Many employers choose to match their employees’ contributions as part of their employee benefits package, with most programs offering a match of up to 3%-6% of employee compensation.
Now, let’s dive into the key features and benefits of 401(k) plans.
Traditional vs. Roth 401(k) Plans
There are two main types of 401(k) plans: traditional and Roth. The main difference between the two is how they’re taxed: traditional 401(k) plans allow for pre-tax contributions, while Roth 401(k) permit after-tax contributions.
Both plans have the same contribution limits, but the withdrawal rules differ.
For 2023, the employee contribution limit for traditional and Roth 401(k) accounts stands at $22,500, with a $7,500 catch-up contribution for those aged 50 and over. Counting employer contributions, the total amount that can be contributed to a 401(k) in 2023 is $66,000, and $73,500 if you account for the catch-up feature.
With traditional 401(k)s, withdrawals are fully taxable at your highest ordinary income rate. This is because you received a tax deduction when the money went into the account.
With Roth 401(k)s, withdrawals are generally tax-free (so long as you’ve had your account open for at least five years). This is because contributions went into the account after tax had already been deducted.
It’s important to consider your personal financial situation and retirement goals when choosing between the two options, if your employer offers both. Some plans don’t come with a Roth option, and there are also companies that don’t offer retirement savings benefits at all.
Nevertheless, you can learn more about the differences between 401(k) and 403(b) plans here and compare 401(k) plans to IRAs here.
Contribution Limits and Catch-Up Contributions
As mentioned, the IRS sets annual contribution limits for both employee and employer contributions to 401(k) plans. Employees aged 50 and older can make additional catch-up contributions to boost their retirement savings — this is especially valuable since they have a shorter runway to retirement and may need more room to save. Staying informed about these limits can help you maximize your retirement savings over the long haul.
The employee contribution limit for traditional and Roth 401(k) accounts in 2023 is $22,500, with a $7,500 catch-up contribution for those aged 50 and over. Counting employer contributions, the total annual 401(k) contribution limit is $66,000, and $73,500 including the catch-up.
Note that the maximum contribution limits for IRAs (Individual Retirement Accounts) are significantly lower than those for 401(k) plans. You’re likely to save far more in the way of tax dollars by contributing fully to a 401(k) plan than by solely maxing out an IRA.
Also note that contribution limits do not include rollovers; most rollovers going between accounts of the same tax treatment will not be subject to income taxes. This is good to know especially if you’re considering rolling over a tax-deferred retirement plan, like a traditional 401(k), to a traditional IRA at an outside provider.
Tax Benefits of a 401(k) Plan
Understanding the tax benefits associated with 401(k) plans is crucial, as they can have a significant impact on your long-run retirement savings. By maximizing tax benefits effectively, you can secure a more stable financial future.
With traditional 401(k)s, you get a tax deduction every time you contribute — up to the IRS-defined annual contribution limits. Traditional 401(k)s make sense if you expect to have a lower tax rate in retirement than during your working career.
With Roth 401(k)s, you voluntarily pay tax on income today and then make contributions to your 401(k) plan. This makes sense if you expect to have a higher tax rate in retirement than during your working career.
Many aspiring retirees practice “tax diversification” by contributing to both types of accounts. This reflects the uncertainty around tax rates in retirement, since there’s no telling exactly how and when tax laws will change, and how a prospective retiree may or may not be impacted.
Pre-Tax Contributions and Tax Deferral
One of the major advantages of a 401(k) plan is the ability to make pre-tax contributions, which reduces your taxable income in the year of contribution. Additionally, your investment earnings within the account grow tax-deferred until withdrawal, providing a significant tax advantage over normal taxable brokerage accounts.
As an example, say you earn $100,000 in 2023. You also contribute $20,000 to your traditional 401(k) plan. Ignoring other income and deductions, you’d owe tax on $80,000 worth of income as opposed to the full $100,000 because you took advantage of your 401(k) plan.
Roth 401(k) and Tax-Free Distributions
The Roth 401(k) option allows for after-tax contributions, which then enables tax-free qualified distributions in retirement. This differs from traditional 401(k) plans, where distributions are taxed as ordinary income upon withdrawal. Weighing the benefits of each type of plan — or, considering the possibility of contributing to both plans — can help you make the best decision for your retirement goals.
Naturally, Roth accounts can offer the added psychological benefit of being tax-free forever — assuming you adhere to the account’s rules. This can come in handy in retirement, especially if you’re already collecting Social Security and have to account for Required Minimum Distributions.
Lower Taxable Income through Pre-Tax Contributions
As noted, by making pre-tax contributions to your 401(k) plan, you’ll lower your taxable income for the year of contribution. All else equal, this can push you into a lower tax bracket and potentially lower your overall tax bill. Repeating the process over many years can lead to long-term tax savings and a more secure financial future.
Tax-Deferred Growth
Tax-deferred growth is another major benefit of traditional 401(k) plans. Investment earnings (along with your initial contributions) grow tax-deferred within the account, allowing for potentially higher returns over time due to compounding (and no tax drag!).
The only “catch” here is that you’ll be taxed at ordinary income tax rates when you withdraw money in retirement. If you withdraw money early (before 59.5), you may be hit with an additional 10% withdrawal penalty — depending on what the money’s for.
All-in-all, tax deferred savings makes sense if you think you’ll be in a lower tax bracket in retirement than you are in now. If you think higher taxes are in your future, you may want to opt for a Roth 401(k) instead of a traditional 401(k).
401(k): Investment Options and Management
A 401(k) plan typically offers various investment options, such as mutual funds, target-date funds, and stable-value funds. Some plans even offer access to annuities. Employees can choose their investment mix based on their risk tolerance and financial goals.
If you’re having trouble making selections, working with a qualified financial advisor (like a CFP or CFA charterholder) equipped to provide investment advice can help you make intelligent investment choices and thereby optimize your retirement savings.
To learn more about finding the investment options in your 401(k) plan, visit our resource library. Alternatively, you can reach out to your plan administrator for more information.
Accessing 401(k) Funds
There are rules surrounding when and how participants can access their 401(k) funds, including when withdrawals are permitted, how Required Minimum Distributions (RMDs) work, and the threat of potential early withdrawal penalties.
In most cases, withdrawals are only permitted without penalty beginning at age 59.5. The IRS maintains a list of exceptions to the rule (see: hardship withdrawals) but they should be seen as true exceptions that shouldn’t be expected to happen frequently (like permanent disability). In other words, the IRS is fairly adamant that 401(k) funds are intended for retirement.
Early withdrawals that don’t qualify for a waiver exception will be subject to a 10% early withdrawal penalty.
RMDs refer to the mandatory distributions you’ll need to take from all tax-deferred retirement accounts beginning the year you turn 73. This is the IRS’ way of ensuring that pre-tax money eventually becomes taxed.
Separately, when changing jobs, plan participants can roll over their 401(k) account to a new employer’s plan or an Individual Retirement Account (IRA) to maintain the tax advantages of their retirement savings vehicle.
Making the Most of Your 401(k) Plan
Staying on top of your 401(k) plan can help maximize its benefits and help to grow your retirement savings. Proper planning, taking advantage of employer matching, and regularly reviewing contributions and newly-released investment options are crucial for making the most of your 401(k).
Enrolling in a 401(k) Plan and Choosing Contribution Rates
Enrolling in a 401(k) plan as soon as possible is essential, as delaying enrollment can have negative consequences on your retirement savings. When enrolling, consider your contribution rate and investment options carefully.
Note that with any investment account, the more you contribute early on in your career will only stand to benefit you many years down the line. Given the laws of compound interest, you should definitely consider upping your contribution rate as high as you can — to the point of maxing out your account if possible.
If hitting the annual maximum feels like too much at the moment, try to contribute at least enough to lock in a full employer match (usually somewhere between 3%-6% of your total compensation).
Taking Advantage of Employer Matching Contributions
Employer matching contributions can significantly boost your retirement savings account balance. Ensure you contribute enough to receive the maximum employer match to make the most of this benefit.
If you’re earning $100,000, and your company agrees to match your contributions up to 4% of salary, a $4,000 contribution on your part would lead to an annual contribution of $8,000 ($4,000 from you, and a $4,000 dollar-for-dollar matching contribution from your employer).
Regularly Reviewing and Adjusting Contributions
Regularly review and adjust your contributions based on changes in your financial situation, retirement goals, and annual IRS contribution limits. Increasing contributions over time, especially after you receive a raise or a bonus, can help maximize your retirement savings.
Diversifying Investments and Rebalancing
Diversifying your investments within a 401(k) plan is essential for a well-rounded portfolio, and equally important for mitigating investment risk. Periodically rebalancing (or shifting your investments to maintain your desired asset allocation and risk level over time) is a core practice within the topic of retirement investing.
Alternative Retirement Savings Options
IRAs are another popular retirement savings vehicle, though you won’t find the grand majority of them attached to an employer. Understanding the differences between traditional and Roth IRAs, their contribution limits, and their tax benefits, can help you decide how to use them alongside a 401(k) plan.
For self-employed individuals and small business owners, there are additional retirement plan options available, such as SEP-IRAs, SIMPLE IRAs, and Solo 401(k) plans. Each option has its unique features and benefits.
To learn more about Roth IRAs, visit our guide here and explore traditional IRAs here.
Frequently Asked Questions (FAQs)
Read on for a list of our most commonly asked questions around 401(k) plans.
What is the difference between a 401(k) and an IRA?
A 401(k) is an employer-sponsored retirement plan, while an IRA (Individual Retirement Account) is a personal retirement savings account that can be opened by any individual at an institution of their choice. Some IRAs, like a SIMPLE IRA, is an employer-sponsored account but falls as more of an exception than the norm when it comes to IRA accounts.
Both 401(k)s and IRAs offer tax advantages, but they have different contribution limits, investment options, and rules around withdrawals.
Can I have both a 401(k) and an IRA?
Yes, you can have both a 401(k) and an IRA, and many people choose to contribute to both types of accounts to maximize their retirement savings. Those interested in more advanced financial planning strategies can find ways to optimize their retirements as a whole by studying the interaction between the two account types.
What happens to my 401(k) if I change jobs?
When you change jobs, you can either leave your 401(k) with your previous employer, roll it over to a new employer’s plan, or roll it over to an Individual Retirement Account (IRA). You can also cash it out, but that will come with costly taxes and penalties.
No matter what you choose to do with your 401(k), be sure you’ve given it some thought.
When can I withdraw money from my 401(k) without penalties?
You can withdraw money from your 401(k) without penalties after reaching age 59½. Withdrawals made before this age may be subject to a 10% early withdrawal penalty.
There are a number of circumstances where withdrawing early may be allowed without penalty, but these scenarios tend to be less common and/or extreme.
Can I borrow money from my 401(k)?
Some 401(k) plans allow participants to borrow money from their account, but this should be considered carefully, as it can impact your long-term retirement savings plan. You’ll be able to borrow up to $50,000 or 50% of your account balance, whichever is less.
You’ll need to pay back the entire loan amount plus calculated interest.
What is a Roth 401(k) and how does it differ from a traditional 401(k)?
A Roth 401(k) is a type of 401(k) plan where contributions are made after-tax, and qualified distributions are tax-free in retirement.
A traditional 401(k), by contrast, has pre-tax contributions and taxable distributions in retirement.
How much should I contribute to my 401(k)?
The amount you should contribute to your 401(k) depends on your financial situation, retirement goals, and the annual IRS contribution limits. It’s important to contribute enough to receive the maximum employer match, if available.
Preparing for a Secure Retirement
Understanding 401(k) plans, pre-tax contributions, and effective management strategies are essential for achieving a secure retirement. Partnering with a trusted professional can help you make informed decisions about your 401(k) plan.
Consider working with Capitalize to find and consolidate your old retirement accounts. Get started today by visiting app.hicapitalize.com/.
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