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What is a 401(k) Plan?

definition

A 401(k) is a retirement account, sometimes matched by an employer contribution that allows workers to save a percentage of their income, tax-deferred.

🤔 Understanding a 401(k)

401(k)s are one of the most widely recognized retirement savings plans in the US and have been used as a way of making tax advantaged savings since the late 70s. They allow workers to plan for saving for retirement while receiving a tax break and deferring taxes until the money is withdrawn. There are several different types of 401ks, including traditional and rollovers, where you put money from an existing 401(k) into a new plan or an Individual Retirement Plan (IRA). And the yearly contribution limit is set at a reasonably high level (currently at $19,000 in the US). Like all retirement plans, 401(k)s come with their pros and cons.

example

Let’s say a fictitious friend Sally is an employee earning $30,000 a year, and she decides to save $3,000 every year through a 401(k) retirement plan. This would give Sally a tax advantage, as she’d only pay taxes on $27,000 of income.

Sally then chooses to set up a medium risk portfolio that includes mutual funds. While she saves, Sally won’t pay any taxes on the returns on her chosen funds or stocks. However, when she retires and her money is withdrawn, Sally will then get taxed on her 401(k) earnings.

Takeaway

Investing in a 401(k) is kind of like baking a cake...

Sort of like a cake, a 401(k) is made up of a variety of ingredients, that bake over time. The level of retirement fund you ultimately develop in a 401(k) will depend on the kinds of ingredients you’ve used (domestic and international stocks, mutual funds, bonds, etc.), the length of time you’ve baked it for (how long you’ve saved), your contributions, investment gains and losses, and other ingredients (like an employment match, where your employer also makes a contribution to your plan).

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Definition of a 401(k)
What does 401(k) stand for?
Who manages a 401(k)?
How to participate in a 401(k) plan?
How to get started with a 401(k)?
What are the different types of 401(k) plans?
What are the advantages & disadvantages of 401(k)s?
How do you contribute to a 401(K) plan?
Can I lose money in my 401(k)?
What are my options if I change employer?
Who’s eligible for a 401(k) plan?

Definition of a 401(k)

The IRS defines a 401(k) as a “defined contribution plan.” A defined contribution plan is based on employee contributions and lets employees and employers contribute/invest regularly over the employee’s working lifetime.

They differ from defined benefit retirement plans, which provide a specified amount in retirement. Instead of depending on contributions, the amount will be based on an employee’s earnings, length of employment, and age.

What does 401(k) stand for?

401(k)s get their name from the US tax code. They first became available in 1978, and were introduced after a group of employees from Kodak went to congress. These employees asked if they would be allowed to invest a percentage of their income in the stock market.

The idea behind this was to protect the money workers invested in stocks from taxation and defer the taxes. Johnson Companies was the first firm to introduce a 401(k) for its employees.

Who manages a 401(k)?

The employer and a nominated administrator are the two main entities involved in the management of a 401(k). Examples of some of the most widely used administrators include Charles Schwab, Paychex, Fidelity Investments, and American Funds.

Your company (if it offers a 401(k) will choose an administrator. The administrator will be responsible for a range of tasks like ensuring your 401(k) plan is in keeping with legislative changes, reviewing and monitoring the 401(k)s performance, compliance, and designing the plan itself.

If you are self-employed, you can set up a solo 401(k), which is managed through an administrator of your choosing.

Aside from the administrator, there are multiple other roles involved that ensure the smooth running of the 401(k). This includes financial advisors, auditors, and regulators that all work with the same purpose in mind.

However, you do have some control over your 401(k) plan. At a minimum, you can change investments quarterly, and likely much more often with resitrctions.

If your employer doesn’t run their 401(k) plan under the US Department of Labor’s guidelines, your employer can decide how often you can change your investments.

How to participate in a 401(k) plan?

Participating in a 401(k) plan is simple. Sometimes, your employer will automatically enlist you in one. If not, the employer will invite you to participate and provide you with a list of investment options, which are typically available through a company’s HR department. The list will include all the plans offered by your employer, otherwise known as the plan sponsor. However, it’s fair to say the options can often be limited and vary depending on the company you’re working for.

If your company doesn’t offer a 401(k), then some workers will pay into an IRA plan. However, one drawback is that there is a limit of $6,000 a year that you can contribute to an IRA, as of 2019.

There are two types of IRA accounts. Traditional IRAs are tax deferred like 401(k)s. Meanwhile, through another type of IRA, called a Roth IRA, individuals contribute taxed money into their accounts upfront, which means they don’t pay taxes on their withdrawals later. There are withdrawal and penalty rules however, based on how long an individual has held their account.

Another option is a Savings Incentive Match Plan for Employees, known as a SIMPLE plan, which allows you to save $13,000 annually in 2019. If you’re aged 50 plus, you can pay an additional $3,000 a year or $16,000 total a year in 2019.

How to get started with a 401(k)?

After opening your 401(k) via your employer, it’s time to start choosing your investments. Ultimately, it’s a matter of choosing which type of investment you’d be most comfortable with. You’ll have a choice of stock funds, blended funds, (which allow you to combine a mix of investments for better diversification and to spread risks), target-date funds (which let you set a target retirement date). With target-date funds, the investments become more conservative the closer you get to retirement. The other investment option is a bond.

Remember to weigh the pros and cons of each option before investing, and make sure you’re clear on any fees that apply.

What are the different types of 401(k) plans?

There are several types of 401(k) retirement savings plans. These include:

Traditional 401(k) plans: This is an employer-sponsored plan where an employee allocates a percentage of their paycheck to their retirement account. This gives the employee a tax break by reducing their taxable income by the amount contributed. Taxes are deferred on contributions, as well as any investment gains, until the saver begins withdrawing funds from their account.

Safe Harbor 401(k): These are a popular choice among small business owners. Every year, company sponsors are obliged to test out 401(k) plans for compliance. A Safe Harbor 401(k) has been pre-approved by the IRS for the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP). ADPs and ACPs are yearly compliance tests set in place by the IRS. They’re in place to ensure a 401(k) plan isn’t overly generous to better-paid employees and less favorable to lower-paid colleagues.

These plans also pass the IRS’s top-heavy tests. The IRS defines Top-heavy plans like this: A plan is top-heavy when, as of the last day of the prior plan year, the total value of key employees’ plan accounts is more than 60% of the total value of the plan assets. So any plan that doesn’t meet that definition passes compliance and is deemed a safe harbor. However, these types of plans are sometimes more expensive.

Roth 401(k) pension plan: Roth 401(k)s differ in that employees use their after-tax dollars to fund them. These are often favored by employees who are in a lower tax bracket during their working life but think they’ll be at a higher rate once they retire.

Small business 401(k): As reported by USA Today, in June 2019, the US government announced the introduction of a retirement plan aimed at small business owners and their 38 million employees. The small business 401(k) was first made available in September 2019.

What are the advantages & disadvantages of 401(k)s?

As with most retirement products, a 401(k) has its pros and cons. Some of the main advantages are:

  • There is the potential to get an employer match, which is basically free money. An employer match can be as much as 6 percent. However, the employer match will depend on the individual company, and not all companies offer one.

  • Workers who contribute to a traditional 401(k) will likely pay lower income taxes, which will give them a tax break.

  • Investments in 401(k)s can be rolled over. For example, if an employee changes jobs, they can take their 401(k) with them.

  • The savings have the potential to grow untaxed (tax-deferred) until it’s time to withdraw the 401(k) at retirement. The main benefit of this is it may keep you in a lower tax bracket during your working life.

  • 401(k)s allow workers to take out loans and hardship payments if they need to. Loans will enable you to take out up to $50,000 or 50 percent of the money saved in your vested accounted (your personal contributions to the 401(k), whichever figure is the least. However, depending on your administrator, there might be a small fee for taking out a loan. Additionally, loans can come with a five-year repayment window, and they must be repaid within the timeframe if you want to avoid taxes and penalties. Some plans that allow general loans for shorter periods. If you fail to make repayments within the specified time or if you become unemployed, you might have to pay it all back within a 30 to 90 day period. Loan repayments are paid back from payroll deductions, and depending on the administrator, you might not be able to make further 401(k) contributions until the loan is repaid. Another disadvantage of taking a loan is the interest rates. Interest will be paid back into the (401(k) plan and will be subject to taxation after it’s withdrawn, leading to double taxation.

  • Employer-provided 401(k)s are generally protected from legal action. They are also protected from creditors under federal law.

Some of the main disadvantages are:

  • An employee can’t withdraw the 401(k) until they reach retirement age, unless they’re willing to potentially pay early withdrawal penalties and income taxes. Hardship withdrawals (which include early withdrawals to cover funeral costs, medical emergencies, and foreclosure prevention) are typically taxable and incur a 10 percent penalty. The penalty fee won’t apply in the cases of disability, if you’re court-ordered to pay financial contributions to a child or to a divorced spouse, or if your paying medical debts amounting to more than 7.5 percent of your adjusted gross income (this includes your pay, plus any dividends or alimony you receive, minus annual costs such as student loan interest or payments to an IRA account). If a person doesn’t pay back the outstanding loan balance, it will be reclassified with a withdrawal and the person will have to pay taxes. A 10% penalty could also apply if the person is under 59 1/2 years old. For these reasons, taking a loan out from a 401(k) should generally be avoided if possible.

  • There is limited flexibility. Employees must invest in the range of 401(k) products currently provided by their employers.

  • As with all plans there are fees and costs associated with retirement plans, so do your research. 401(k) fees include investment and administrative fees along with service charges. A CNBC news report shows that the average fees are 0.45 percent a year. However, they can be as much as 3 percent.Each administrator will have their own set of fees. Your employer might cover ongoing costs, or you might decide the benefits of a 401(k) make it a better choice than an IRA.

How do you contribute to a 401(K) plan?

There are several things you’ll want to consider when contributing to a 401(k) plan. The main factor to think about is how much you think you’ll need to live comfortably in retirement. You will also want to look at what your employer’s contribution is and match this if possible.

The amount employers contribute to your 401(k) varies considerably, with some not contributing at all. Some companies match as little as three percent, with others matching as much as six or even seven percent.

As for how much you should contribute personally, there is no single answer. Everyone will have different needs and goals for their retirement. Generally, experts suggest contributing between 10 to 30 percent of your income. However, the amount you commit is often affected by your other financial commitments.

Remember, the investments in your 401(k) plan are not final. You can change the nature of the investment if you’re unhappy with the way they’re performing, etc.

Can I lose money in my 401(k)?

It would be difficult to lose your contributions in your 401(k) plan in its entirety. However, there can be some circumstances when your employer could feasibly close your 401(k) if you’re leaving the company. If it’s less than $1,000, your employer is entitled to ask you to transfer your vested amount out of the 401(k) if you leave their employment.

401(k) balances are protected in the case of bankruptcy. While your money should be safe, you cannot withdraw the funds during a Chapter 13 bankruptcy without permission from your bankruptcy trustee and the courts. If you borrow money from your 401(k) without this permission, it may be considered income that has to go towards paying off your debts.

As you can see, 401(k)s are a popular way to put aside retirement savings. However, as with all investments, it’s important to remember that their value can rise and fall at any time.

As your plan performs only as well as the underlying investments will allow it, it’s possible that at some point you might find that your investment is worth less than your initial contribution.

What are my options if I change employer?

If you change employers, you’d have four options for handling your 401(k):

  1. Leaving the 401(k) with your current employer
  2. Rolling it over to your new company
  3. Opting for an IRA rollover
  4. Cashing out. However, while this would give you access to your money, it could also mean added taxation, the risk of penalties and a lower retirement pot.

Before deciding, you must carefully consider each option and which one seems most beneficial for you in the long term.

Leaving the 401(k): If your 401(k) has enough money in it (usually $5,000 or more) then most employers will give you the option of leaving it with them even after you quit. You won’t be able to make any additional contributions, but you can leave the money to grow. This might be a good choice if your new employer doesn’t offer a 401(k) or has a plan with higher fees.

Rolling over the 401(k): If your new employer offers a 401(k) plan as well, you have the option of rolling your funds over to the new plan. If fees and plan offering are similar, this may be a worthwhile move. It enables you to have all your funds in one place, which makes it easier to monitor and manage your savings.

Rolling over to an IRA: A Rollover IRA enables you to move money from a 401(k) with a previous employer to an IRA. If your new employer doesn’t offer a 401(k), this may be an option to consider, as taxes can still be deferred until withdrawal, and there are no penalties for rolling over. There are pros and cons to both 401(k)s and IRAs so its important to do your research before determining if this is the best option for you.

Cashing out: You can choose to cash out your funds when leaving an employer, but it’s usually not the best option. While this would give you access to your money, it can also mean added taxation, the risk of penalties, and a lower retirement pot.

Who’s eligible for a 401(k) plan?

Eligibility for a 401(k) comes under the Internal Revenue Code (IRC) Section 401(a). The IRS sets the standards for retirement plans, including eligibility. To qualify, you need to be:

  • Employed
  • Aged over 21 and working for an employer for one year, or in some circumstances, two.

Independent contractors and freelancers will be covered by a self-employed 401(k) plan and seasonal workers won’t be covered if a company excludes them in the plan document.

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