The 401k plan, originating accidentally from a section of the Internal Revenue Code, is designed to encourage employees to save for retirement. As the popularity of pensions as a retirement tool has decreased, 401ks have taken the way. By providing tax advantages and, often, employer-matching contributions, these accounts help workers build a substantial nest egg for their post-working years.
Types of 401k Plans
- Traditional 401k:
- This is the most common type of 401k plan and is usually referred to as just a "401k plan".
- Contributions are made with pre-tax dollars, which reduces taxable income in current calendar years.
- Taxes are paid upon withdrawal.
- In 2024, an employee can contribute up to $23,000, with an additional $7,500 catch-up contribution for those 50 and older. Employers can match contributions, bringing the grand total to at most $69,000 (or $76,500 for those 50 or older).
- Roth 401k:
- Contributions are made with after-tax dollars (like Roth IRA accounts, also a popular retirement vehicle).
- Withdrawals are tax-free in retirement, provided certain conditions are met, such as the length of account ownership (5 years) and age (59½ years).
- Contribution limits are the same as Traditional 401k's, and if individuals have both Traditional and Roth 401k accounts, the contribution limit is cumulative. For example, if Blake, age 36, has already contributed $15,000 to their Traditional 401k, they'd only be able to contribute $8,000 to their new Roth 401k.
- SIMPLE (Savings Incentive Match Plan for Employees) 401k:
- Contributions are made with pre-tax dollars, which reduces taxable income in current calendar years.
- Taxes are paid upon withdrawal.
- In 2024, employee contribution limits are $16,000, with an additional catch-up contribution of $3,500 for those aged 50 and older. Employers can match up to 3% of the employee's salary if they elect a contribution or a 2% non-elective contribution for each employee.
- Subject to the same withdrawal stipulations as Traditional and Roth 401k's.
Self-employed individuals can also choose to open a Solo or Self-Employed 401k. These plans have both Traditional and Roth options, with similar stipulations as above.
Employer Matching
Many employers match a portion of employee contributions, usually up to a certain percentage of that employee's salary. Vanguard reports that about half of U.S. companies offer up to 6% 401k matching. This is free money and a significant incentive to participate in the plan.
401k Investment Options
Like other retirement accounts, 401k plans offer a range of investment choices to compound original investments, often including:
- Mutual funds
- Stocks
- Bonds
- And other securities.
The specific portfolio options depend on the plan provider (who the employer chooses). Typically, initial funds are invested more aggressively for higher chances of return and grow more conservative as the account holder nears retirement.
Vesting of 401k Funds
Employer 401k contributions may be subject to vesting and a vesting schedule, meaning employees must stay with the company for a certain amount of time before they fully own the employer-contributed funds. It's always good to verify any vesting schedule before leaving a job. Generally, vesting schedules can't exceed 3-6 years.
Withdrawal Rules
- Early Withdrawal: Withdrawals before age 59½ are subject to a 10% penalty and income tax at the present rate.
- Required Minimum Distributions (RMDs): Starting around age 70, individuals must take minimum distributions or withdrawals from their 401k. The IRS calculates these RMDs based on life expectancy and the balance in the account, but as a general rule of thumb, in 2024, RMDs are required at:
- 73 if you turn age 72 on or after Jan. 1, 2023
- 72 if you turn 70½ between Jan. 1, 2020, and Dec. 31, 2022
- 70½ if you turned that age on or before Dec. 31, 2019
- If the required amount isn't taken out, a hefty penalty of 50% can be incurred on the amount that should have been withdrawn but wasn't. Account holders can also take more than the RMD, but not less.
Benefits of a 401k
- Tax Advantages: Tax-deferred growth for traditional 401k plans; tax-free withdrawals for Roth 401ks. Tax-free growth.
- Employer Match: Enhances savings without additional employee contribution.
- Automated Savings: Payroll deductions make saving effortless and more likely.
- Compound Interest: Over time, investments grow exponentially due to compounding returns.
Strategies for Maximizing a 401k
- Contribute Enough to Get the Full Employer Match: Maximize the benefit of free money from your employer.
- Increase Contributions Gradually: Aim to increase your contribution rate annually or with each raise.
- Diversify Investments: Like any other investment, spread funds across different asset classes to balance risk and reward. This way, most of the money can't be wiped out by one economic event; there is a pool of thriving capital to draw from.
- Stay Informed: Review and adjust your investment choices based on performance and retirement goals.
