Most businesses work with a vendor to offer their employees 401(k) retirement plans, but they don’t always explain what they are and why you might need one. In this brief 401(k) guide, we will examine what 401(k) plans are, how they work, and why they are a good investment.
The 401(k) Explained
A 401(k) explained simply is a retirement savings account that lets you put a portion of your salary into long-term investments. 401(k) plans are usually offered by businesses as part of their benefits package to employees. 401(k) plans are attractive to employees because:
- You don’t pay income tax on the money you invest.
- Your employer normally makes a matching contribution, doubling your investment.
The name “401(k)” refers to the subsection in the Internal Revenue Code to which the plan refers. The subsection defines the specific tax laws governing the plan.
401(k) Investing 101
A 401(k) plan helps you save for retirement by means of a deduction from your paycheck every time you are paid. This money is considered pre-tax, so you don’t pay income tax on the deduction.
Your 401(k) is considered a “qualified” retirement plan, which means it can receive special tax benefits. There are two types of qualified plans: defined-contribution and defined benefit. The 401(k) plan is a defined-contribution plan. This means the money in your plan comes from the contributions you and your employer make, plus whatever gains you make from your investments.
The money you pay into the 401(k) is invested into one or more funds of your choice, normally from a selection of mutual funds. These might include:
- Index funds.
- Real estate funds.
- Bond funds (ranging from aggressive growth to conservative income).
There are risks with any investment, but typically your 401(k) should grow over time. For example, a contribution of $5,000 per year for 30 years typically produces a $150,000 investment. With the stock market’s historical average return rate, through compound growth, that investment could grow to $750,000.
A 401(k) 101 tip is that investing through your 401(k) is typically better than using a standard brokerage account because you don’t have to pay capital gains tax if you sell an investment at profit. You are also not liable for dividend tax on dividends generated by your investments.
When you retire, you can receive payments from your 401(k) in the form of regular installments, like a paycheck. This money is subject to income tax, though you will probably be at a lower tax rate since your income will be less.
The vendor managing your 401(k) will either direct-deposit your payments or send you a monthly or bi-monthly check, depending on what you arrange with them. They will usually take care of taxes, too.
Alternatively, you can move the balance of your 401(k) plan to a traditional Individual Retirement Account (IRA) or a Roth IRA. Doing this can expand your investment options.
Making Withdrawals from Your 401(k) Plan
There are certain conditions you must meet if you want to withdraw money from your 401(k) plan. These are:
- You retire or leave your job.
- You turn 59½ years old.
- You experience a hardship, as defined by the plan, in your life.
- You become disabled or you die.
- The plan ends.
If you make an early withdrawal from your 401(k) plan, that withdrawal will incur income taxes since it is considered income. It is also likely you will have to pay a 10% penalty.
Required Minimum Distributions
According to IRS regulations, unless you are still working, starting from age 70½, you have to make Required Minimum Distributions (RMDs) from your 401(k) account. These are simply withdrawals from your account. You can delay when you begin withdrawing money, but you cannot delay any longer than April 1 of the year following the year you turn 70½, otherwise you will incur tax penalties.
Transferring Your 401(k)
If you need to move your 401(k) to another account, for example if you change jobs, there are two ways to do this. You can opt for a direct rollover, where the money from your old 401(k) is funneled directly to your new account with no tax charges.
Alternatively, you can opt for an indirect rollover. With an indirect rollover, the money from your 401(k) goes to you first, and you then deposit it into your new account. You are liable for the income tax on the amount you transfer when you pay your taxes.
Roth 401(k) Plans
The Roth 401(k) plan operates just like your traditional 401(k) plan. Your company deposits a portion of your income into the plan, you make your investment selections, and then take money out when you retire. The main difference is that, unlike the traditional 401(k), you pay tax on the money you contribute.
Contributions to a traditional 401(k) are tax-free. However, you then pay taxes on withdrawals when you retire. With a Roth 401(k), you have already paid income tax on the contributions so you don’t have to pay tax on either your contributions or your investment earnings.
Borrowing Money from Your 401(k) Plan
Your employer may allow you to borrow from your 401(k) plan if you need to. You are limited to borrowing no more than 50% of the vested balance up to $50,000. Normally, you need to repay the loan within five years unless you are using the money for a primary home purchase.
You will also pay interest on your loan at a rate comparable to the rate you would get for the same kind of loan from a lending institution.
Whatever you fail to repay is considered a distribution and will be taxed and penalized as such.
Alternatives to a 401(k) Plan
If your employer doesn’t offer a 401(k) plan, you can set up an IRA with an investment firm. An IRA works a lot like a 401(k) in that you contribute money to the plan and your investment grows over time. You can then withdraw this money when you retire.
Another option for you if your employer doesn’t offer a 401(k) plan, is to deduct your contributions when you file your income taxes. This is no different than a family paying down a home mortgage. As with a 401(k), you will have to pay taxes on the money you withdraw when you retire.
If you are interested in learning more about 401(k) plans, download this 401(k) fact sheet from Human Interest. There you will find 401(k) explained simply for beginners and useful information for more seasoned investors.