Since its inception in 1978, the 401(k) plan has grown to become the most popular type of employer-sponsored retirement plan in America. Millions of workers depend on the money they have invested in these plans to provide for them in their retirement years, and many employers see a 401(k) plan as a key benefit of the job. Few other plans can match the relative flexibility of the 401(k).
- A 401(k) is a qualified retirement plan, which means it is eligible for special tax benefits.
- You can invest a portion of your salary, up to an annual limit.
- Your employer may or may not match some part of your contribution.
- The money will be invested for your retirement, usually in your choice of a variety of mutual funds.
- You can't usually withdraw any of the money without a tax penalty until you're 59½.
What Is a 401(k) Plan?
A 401(k) plan is a retirement savings account that allows an employee to divert a portion of their salary into long-term investments. The employer may match the employee's contribution up to a limit.
A 401(k) is technically a "qualified" retirement plan, meaning it is eligible for special tax benefits under IRS guidelines. Qualified plans come in two versions. They may be either defined contribution or defined benefit, such as a pension plan. The 401(k) plan is a defined contribution plan.
That means that the available balance in the account is determined by the contributions made to the plan and the performance of the investments. The employee must make contributions to it. The employer may choose to match some portion of that contribution or not. The investment earnings in a traditional 401(k) plan are not taxed until the employee withdraws that money, typically after retirement. After retirement, the account balance is entirely in the hands of the employee.
More than 100 million Americans are covered by defined-contribution plans, like a 401(k) or similar, nearly half of U.S. workers in the private sector. And nearly half of those plans are immediately vested participants in employer matching contributions, according to a 2019 report by Vanguard.
The Roth 401(k) Variation
While not all employers offer it, the Roth 401(k) is an increasingly popular option. This version of the plan requires the employee to pay income tax immediately on the contributions. However, after retirement, the money can be withdrawn with no further taxes due on either the contributions or investment earnings.
Employer contributions can only go into a traditional 401(k) account—not a Roth.
401(k) Contribution Limits
The maximum amount of salary that an employee can defer to a 401(k) plan, whether traditional or Roth, is $19,500 for 2021 (remaining the same as 2020). Employees aged 50 and older can make additional catch-up contributions of up to $6,500 in 2021 (also the same as 2020).
The maximum joint contribution by both employer and employee is $58,000 for 2021 (up from $57,000 in 2020), or $64,500 for those aged 50 and older (up from $63,500 for 2020).
Limits for High Earners
For most people, the contribution limits on 401(k)s are high enough to allow for adequate levels of income deferral. In 2021, highly paid employees can only use the first $290,000 of income when computing the maximum possible contributions.
Employers also can provide non-qualified plans such as deferred compensation or executive bonus plans for these employees.
401(k) Investment Options
A company that offers a 401(k) plan typically offers employees a choice of several investment options. The options are usually managed by a financial services advisory group such as The Vanguard Group or Fidelity Investments.
The employee can choose one or several funds to invest in. Most of the options are mutual funds, and they may include index funds, large-cap and small-cap funds, foreign funds, real estate funds, and bond funds. They usually range from aggressive growth funds to conservative income funds.
Rules for Withdrawing Money
The distribution rules for 401(k) plans differ from those that apply to individual retirement accounts (IRAs). In either case, an early withdrawal of assets from either type of plan will mean income taxes are due, and, with few exceptions, a 10% tax penalty will be levied on those younger than 59½.
However, while an IRA withdrawal doesn't require a rationale, a triggering event must be satisfied to receive a payout from a 401(k) plan.
The following are the usual triggering events:
- The employee retires from or leaves the job.
- The employee dies or is disabled.
- The employee reaches age 59½.
- The employee experiences a specific hardship as defined under the plan.
- The plan is terminated.
The IRS mandates 401(k) account owners to begin what it calls required minimum distributions (RMDs) at age 72 unless that employer still employs the person. This differs from other types of retirement accounts. Even if you're employed, you have to take the RMD from a traditional IRA, for example.
Money withdrawn from a 401(k) is usually taxed as ordinary income.
Following the passage of the Setting Every Community Up For Retirement Enhancement (SECURE) Act in December 2019, the age for RMDs was raised from 70½ to 72.
The Rollover Option
Many retirees transfer the balance of their 401(k) plans to a traditional IRA or a Roth IRA. This rollover allows them to escape the limited investment choices that are often present in 401(k) accounts.
If you decide to do a rollover, make sure you do it right. In a direct rollover, the money goes straight from the old account to the new account, and there are no tax implications. In an indirect rollover, the money is sent to you first, and you will owe the full income taxes on the balance in that tax year.
If your 401(k) plan has employer stock in it, you are eligible to take advantage of the net unrealized appreciation (NUA) rule and receive capital gains treatment on the earnings. That will lower your tax bill significantly.
To avoid penalties and taxes, a rollover must take place within 60 days of withdrawing funds from the original account.
401(k) Plan Loans
If your employer permits it, you may be able to take a loan from your 401(k) plan. If this option is allowed, up to 50% of the vested balance can be borrowed up to a limit of $50,000. The borrower must repay the loan within five years. A longer repayment period is allowed for a primary home purchase.
The CARES Act doubled the amount of 401(k) money available as a loan to $100,000 in 2020, but only if you’ve been impacted by the COVID-19 pandemic and if your plan allows loans.
In most cases, the interest paid will be less than the cost of paying real interest on a bank or consumer loan—and you will be paying it to yourself. But be aware that any unpaid balance will be considered a distribution and taxed and penalized accordingly.