LAST REVIEWED Oct 29 2020 9 MIN READ
401(k) plans are different from both savings accounts, where your money is easily accessible, and traditional pension plans where employers are responsible for providing employees with a set amount of money upon retirement.
There are two basic 401(k) plans to choose from: Roth 401(k)s and traditional 401(k)s. While they share several similarities, employees and employers can contribute to both types, and each is taxed in different ways. As employers move away from pensions, it’s important for employees and employers to understand what a 401(k) plan is, how it works, the different types of 401(k)s available, and any special considerations that go along with them when changing jobs.
What Is a 401(k) Plan?
Named after a U.S. Internal Revenue Code section, a 401(k) plan is a defined-contribution, tax-advantaged retirement account many employers offer to employees. Employees can contribute to 401(k) accounts via automatic payroll withholding, and employers can deposit an additional amount into the account regularly if they choose.
Only employers can sponsor 401(k) accounts and make them available to employees. Individual employees then decide on the amount they want to be withheld from their paychecks and deposited into their accounts subject to IRS rules and plan limits. From there, employers can choose to:
Match employee contributions or a portion of them or not provide a match at all.
Automatically enroll employees as a default and have employees elect to opt-out if desired.
Have employees opt-in to the program themselves.
Understanding 401(k) Plans
Employers are responsible for running the plan according to any regulations, laws, and rules as well as any provisions established by the plan itself. These responsibilities can include:
Identifying who is eligible to join the plan.
Determining how much and how often plan enrollees can contribute.
Determining how much, if any, the employer will contribute.
Determining what investment options will be available.
Determining how often enrollees can reallocate investment assets.
Hiring necessary vendors to manage the plan.
Establishing any plan features, including loans, hardships, or withdrawals.
Ensuring the plan is compliant with federal rules and reporting to government agencies, as required.
Sharing plan updates and providing other communications to participants.
Employees decide if they want to participate in a 401(k) plan and, if so, the amount they wish to contribute.
For example, if an employee earns $1,500 each pay period and decides to contribute 3% of their pay, $45 will be taken out and deposited into their 401(k) account each pay period. This amount is deducted pre-tax, meaning that contributing to a 401(k) plan lowers the amount the employee pays in income tax. Instead of being taxed on the entire $1,500 each pay period, an employee is only taxed on $1,455 ($1,500 salary – $45 401(k) contribution = $1,455).
401(k) Contribution Limits
No income tax is owed on money contributed to the 401(k) plan until the employee makes a withdrawal from the 401(k) account, which is typically in retirement and when they’re in a lower tax bracket.
To account for inflation, the maximum amount employees and employers can contribute to 401(k) plans is periodically adjusted. For 2022, the annual employee contribution limit is $20,500 for workers who are under the age of 50 years old and $27,000 for workers age 50 or older. Employer contributions or additional after-tax, non-deductible employee contributions raise the limit for workers under the age of 50 to 100% of the worker’s compensation or $57,000 (whichever is lower) and $63,500 for workers age 50 or older.
Employers who have chosen to match employee contributions to 401(k) accounts use numerous formulas for calculating the match. For example, an employer may contribute 50 cents for every dollar the employee contributes up to a set percentage of their salary. Financial advisors typically recommend individuals contributing at least enough money to their 401(k) accounts to receive the maximum employer match available.
Taking Withdrawals From a 401(k) Plan
Both traditional 401(k)s and Roth 401(k)s usually have Required Minimum Distributions or withdrawals (RMDs). Individuals reaching 72 years of age are required to withdraw a set percentage from their 401(k) account. Employees may not be subject to RMDs if they are still working for the employer who manages their 401(k) account. Note for 2020: RMDs are not required this year as a result of legislation in the CARES Act following the government’s response to the coronavirus pandemic.
Withdrawals from 401(k)s are typically not taken until retirement, after having decades for your investments to grow. Traditional 401(k) earnings are tax-deferred, meaning withdrawals are taxed as regular income. Since they were taxed before being deposited, Roth 401(k) withdrawals are tax-free.
Traditional 401(k) Versus Roth 401(k)
Before Roth 401(k)s became available in 2006, employers and employees only had traditional 401(k)s available to them. Traditional 401(k)s, with their immediate tax breaks, may be more attractive to employees who expect to be in lower marginal tax brackets after retirement.
Younger employees with lower salaries who expect to make more over time may choose a Roth 401(k) to avoid taxes later on when they’re likely to be in a higher tax bracket. Any money earned from contributions to a Roth 401(k) is not taxed, which is an important factor to consider especially if the account has decades to grow. Financial advisors usually recommend making contributions to both types of accounts since no one can predict future tax rates.
Special Considerations: Changing Jobs
Withdrawing money from a 401(k) account is generally a bad idea unless you are in desperate need of cash for something important, like medical bills. In addition to the money being taxable for the year in which you withdraw it, you may also incur an additional 10% tax for early distribution unless you are totally and permanently disabled, over 59 1/2 years old, or meet other IRS criteria exempting you from the rule. Other options to consider include:
Rolling it over into an IRA.
Leaving it with the employer you are leaving.
Moving it to your new employer.
Employee contributions can be withdrawn without penalty and tax-free from a Roth IRA at any time. However, earnings are taxable if the employee has had the account for under five years, and the worker is less than 59 1/2 years old. Even if the worker can take the money out tax-free, they will be decreasing their savings for retirement, a decision they may regret later on.
Could your employer use help to improve your workplace’s current retirement plan? Are you ready to switch to a 401(k) that’s great for both employers and employees? Talk to your company about Human Interest. With expertise in designing flexible plan options including profit-sharing, vesting, matching contributions, and eligibility we’re a 401(k) administrator that works for almost any situation. Schedule a consultation with one of our representatives today and learn more about the options available.
The Human Interest Team
We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment education, and integration with leading payroll providers.