Chances are that you’ve heard about various 401(k) benefits. But even if you already have one of these employer-sponsored retirement plans, you might not understand exactly how a 401(k) works. Of course, the more you know about 401(k)s, the more you'll be able to take advantage of those 401(k) benefits.
More than 80 million workers actively participate in 401(k)s, with more than half-a-million different company plans in place, according to a January 2019 report by the American Benefits Council. Overall, a dizzying $5.7 trillion in assets are held within 401(k)s in the U.S.
- You can deduct your 401(k) contributions from your tax return in the year that you make them.
- A 401(k) employer match can help you grow your nest egg even faster.
- 401(k)s offer protection from creditors, including the IRS, in some cases.
- Roth 410(k)s are ideal for high earners who aren't eligible to contribute to a Roth IRA and for people who expect to be in a higher tax bracket in retirement.
What Is a 401(k)?
Named after a section of the Internal Revenue Code, 401(k)s are employer-sponsored defined-contribution plans (DC) that give workers a tax-advantaged way to save for retirement.
If your employer offers a 401(k), you can opt to contribute a percentage of your income to the plan. The contributions are automatically taken out of your paycheck, and you can deduct them on your taxes.
Withdrawals from your 401(k) are taxed at your prevailing income-tax rate when you take money out. There are restrictions on how and when you can withdraw money from the account.
If you withdraw funds from a 401(k) before you reach age 59½, you’ll be hit with a 10% early-withdrawal penalty fee as well as any applicable taxes. At age 72, you must begin taking required minimum distributions (RMDs) from the plan. Previously, the RMD was 70½, but following the passage of the Setting Every Community Up For Retirement Enhancement (SECURE) Act in December 2019, the RMD age is now 72.
If you're still working at age 72, you don't have to take RMDs from the plan at your current workplace (see below for details). You will, however, need to start making withdrawals from 401(k)s at any former employers if you have any.
401(k)s offer workers a lot of benefits, including:
- Tax breaks
- Employer match
- High contribution limits
- Contributions after age 72
- Shelter from creditors
Below, we'll take a closer look at these 401(k) benefits.
The tax advantages of a 401(k) begin with the fact that you make contributions on a pre-tax basis. That means you can deduct your contributions in the year you make them, which lowers your taxable income for the year.
To compound the benefit, your 401(k) earnings accrue on a tax-deferred basis. That means the dividends and capital gains that accumulate inside your 401(k) are also not subject to tax until you begin withdrawals.
The tax treatment can be a significant benefit if you’ll be in a lower tax bracket in retirement—when you take money out—than you are when you make the contributions.
Some employers offer to match the amount you contribute to your 401(k) plan. And some even add a profit-sharing feature that contributes a portion of the company's profits to the pot as well. If your company offers one or both of these features, sign up for them—they essentially represent free money.
Here's how those employer perks can work. Many companies offer to match 50% of up to the first 6% you contribute to a 401(k). Let’s say you earn a $45,000 salary. If you contribute 6% of your annual earnings ($2,700) to your 401(k), your employer would contribute an additional 50% of that amount. That’s $1,350 of easy money.
Some employers even go one better and match your contributions dollar-for-dollar for up to the first 6%, which would add another $2,700 in this scenario, thus doubling your annual contributions to the plan.
401(k) Contribution Limits
You can save much more each year in a 401(k) than in an IRA. For 2020 and 2021, the 401(k) contribution limits are $19,500 and $26,000 (includes a $6,500 catch-up for those age 50 and older), respectively.
Your employer can contribute, too. For 2020, that combined limit goes up to $57,000, or $63,500 with the catch-up contribution. In 2021, the contribution limit goes up to $58,000, or (with the $6,500 catch-up) $64,500.
401(k) Contributions After Age 72
With some retirement accounts, you cannot contribute once you turn 72, even if you’re still working. That means any money you might have contributed on a pre-tax basis is instead taxed at your current rate. And that's likely to be higher than the rate you'll pay once you retire.
Notably, 401(k)s don't have this drawback. You can continue to contribute to these for as long you're still working. Even better, while you're working, you're spared from taking mandatory distributions from the plan provided you own less than 5% of the business that employs you.
Shelter From Creditors
If you run into financial trouble, it's helpful to have your money in places that creditors cannot access. As it happens, 401(k)s offer excellent creditor protection. That’s because these plans are set up under the Employee Retirement Income Security Act (ERISA)—and ERISA accounts are generally protected from judgment creditors.
Additionally, 401(k)s often offer some protection from federal tax liens, which are government claims against the assets of a taxpayer with unpaid back taxes. The fact that 401(k) plans legally belong to your employer, rather than you, makes it difficult for the IRS to place a lien on the account. Depending on the language in the fine print of your account, your plan administrators may be able to refuse outright to comply with an IRS lien.
The advantages of contributing pre-tax income to a regular 401(k) when your earnings (and tax rate) are at their peak may diminish as your career is winding down. Indeed, your income and tax rate may actually rise as you get older, as Social Security payments, dividends, and RMDs kick in—especially if you keep working.
Enter a different flavor of retirement account—the Roth 401(k). An ever-increasing number of companies offer Roth 401(k)s. Like its sibling, the Roth IRA, this account receives your contributions as after-tax dollars, but withdrawals are then fully tax-free as long as you meet certain conditions.
Roth 401(k) Limits
Roth 401(k) contribution limits follow those of 401(k)s—not Roth IRAs. For 2020, that combined limit goes up to $57,000, or $63,500 with the catch-up contribution. and in 2021 that amount is $58,000, or $64.500 with the catch-up contribution.
Roth 410(k)s are also an ideal avenue for high earners who want to invest in a Roth but may have their contributions to a Roth IRA limited by their income. For example, if you are a single person, you can't contribute to a Roth IRA in 2020, if your modified adjusted gross income (MAGI) is $139,000 or more, and in 2021 that amount goes up to $140,000, but there are no income limits for contributing to a Roth 401(k).
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The Bottom Line
It’s little wonder that the 401(k) is the most popular employer-sponsored retirement plan in the nation. With the numerous 401(k) benefits, this savings plan should be part of your retirement financial portfolio, especially if your employer offers a match.
Once you're aboard with a 401(k), however, don't simply sit back and allow it to run on auto-pilot. Changes from year to year in contribution limits, tax advantages, and your financial needs make it prudent to regularly review your plan's performance and any alternatives that may suit you better.