If you are like many Americans, you likely have an employer-sponsored retirement plan. This is the first article in a three-part series about the basics of 401k, 403b, and Defined Benefit Plans.
Retirement plans established under Section 401(k) of the Internal Revenue Code, commonly referred to as “401(k) plans,” have become one of the most popular types of employer-sponsored retirement plans.
A 401(k) plan is an employer-sponsored retirement savings plan that offers significant tax benefits while helping you plan for the future. You contribute to the plan via payroll deduction, which can make it easier for you to save for retirement. One important feature of a 401(k) plan is your ability to make pre-tax contributions to the plan. Pre-tax means that your contributions are deducted from your pay and transferred to the 401(k) plan before federal (and most state) income taxes are calculated. This reduces your current taxable income — you don’t pay income taxes on the amount you contribute, or any investment gains on your contributions until you receive payments from the plan.
For example, Melissa earns $50,000 annually. She contributes $5,000 of her pay to her employer’s 401(k) plan on a pre-tax basis. As a result, Melissa’s taxable income is now $45,000. She isn’t taxed on her contributions ($5,000), or any investment earnings until she receives a distribution from the plan.
You may also be able to make Roth contributions to your 401(k) plan. Roth 401(k) contributions are made on an after-tax basis, just like Roth IRA contributions. Unlike pre-tax contributions to a 401(k) plan, there’s no up-front tax benefit — your contributions are deducted from your pay and transferred to the plan after taxes are calculated. But a distribution from your Roth 401(k) account is entirely free from federal income tax if the distribution is qualified. (See the section below on income tax consequences for more detail.)
Generally, you can contribute up to $19,500 ($26,000 if you’re age 50 or older) to a 401(k) plan in 2020 (unless your plan imposes lower limits). If your plan allows Roth 401(k) contributions, you can split your contribution between pre-tax and Roth contributions any way you wish.
Keep in mind that if you also contribute to another employer’s 401(k), 403(b), SIMPLE, or SAR-SEP plan, your total contributions to all of these plans — both pre-tax and Roth — can’t exceed $19,500 in 2020 ($26,000 if you’re age 50 or older). It’s up to you to make sure you don’t exceed these limits if you contribute to plans of more than one employer.
While a 401(k) plan can make you wait up to a year to participate, many plans let you begin contributing with your first paycheck. Some plans also provide for automatic enrollment. If you’ve been automatically enrolled, make sure to check that your default contribution rate and investments are appropriate for your circumstances.
Yes. Your participation in a 401(k) plan has no impact on your ability to contribute to an IRA (Roth or traditional). You can contribute up to $6,000 to an IRA in 2020 ($7,000 if you’re age 50 or older) if you have at least that much in earned income. Your ability to make deductible contributions to a traditional IRA may be limited if you participate in a 401(k) plan, depending on your salary level.
When you make pre-tax 401(k) contributions, you don’t pay current income taxes on those dollars. But your contributions and investment earnings are fully taxable when you receive a distribution from the plan. In contrast, Roth 401(k) contributions are subject to income taxes upfront, but qualified distributions of your contributions and earnings are entirely free from federal income tax. A distribution is qualified if it meets the following requirements:
The five-year waiting period for qualified distributions starts on January 1 of the year you make your first Roth contribution to the 401(k) plan. For example, if you make your first Roth contribution to your employer’s 401(k) plan in December 2020, your five-year waiting period begins January 1, 2020, and ends on December 31, 2024.
Withdrawals from pre-tax accounts prior to age 59½ and non-qualified withdrawals from Roth accounts will be subject to regular income taxes and a 10% penalty tax unless an exception applies. Due to the Coronavirus Aid, Relief, and Economic Security (CARES) Act, penalty-free withdrawals of up to $100,000 may be allowed in 2020 for qualified individuals affected by COVID-19. Individuals will be able to spread the associated income over three years for income tax purposes and will have up to three years to reinvest withdrawn amounts.
Employers don’t have to contribute to 401(k) plans, but many will match all or part of your contributions. Your employer can match your Roth contributions, your pre-tax contributions, or both. But your employer’s contributions are always made on a pre-tax basis, even if they match your Roth contributions. That is, your employer’s contributions, and investment earnings on those contributions, are always taxable to you when you receive a distribution from the plan.
Try to contribute as much as necessary to get the maximum matching contribution from your employer. This is essentially free money that can help you pursue your retirement goals.
If you think you’ll be in a higher tax bracket when you retire, Roth 401(k) contributions may be more appealing, since future withdrawals, assuming they’re qualified, will generally be tax-free. However, if you think you’ll be in a lower tax bracket when you retire, pre-tax 401(k) contributions may be more appropriate because your contributions reduce your taxable income now. Your investment horizon and projected investment results are also important factors.
When you terminate employment, you generally forfeit all contributions that haven’t vested. (Vesting means that you own the contributions.) Your contributions and the earnings on them are always 100% vested. But your 401(k) plan may require up to six years of service before you fully vest in employer matching contributions and associated earnings (although some plans have a much faster vesting schedule).
When you terminate employment, you can generally leave your money in your 401(k) plan, although some plans require that you withdraw your funds once you reach the plan’s normal retirement age (typically age 65). Your plan may also “cash you out” if your vested balance is $5,000 or less, but if your payment is more than $1,000, the plan generally must roll your funds into an IRA established on your behalf, unless you elect to receive your payment in cash. [This $1,000 limit is determined separately for your Roth 401(k) account and the rest of your funds in the 401(k) plan.]
You can also roll all or part of your Roth 401(k) dollars over to a Roth IRA, and your non-Roth dollars to a traditional IRA. You may also be able to convert your non-Roth dollars to a Roth IRA, but income taxes will apply to any tax-deferred amounts in the year of conversion. You may also be able to roll your funds into another employer’s plan that accepts rollovers.
Finally, you may also be able to take a cash distribution of your contributions and earnings, as well as any vested employer amounts. However, keep in mind that any tax-deferred funds will be subject to income taxes and a possible 10% penalty tax if you’re under the age of 59½ and an exception does not apply. (As noted above, an exception to the penalty tax may be allowed in 2020 for qualified participants affected by the coronavirus for distributions up to $100,000.)
Note: When considering a rollover, to either an IRA or to another employer’s retirement plan, you should consider carefully the investment options, fees and expenses, services, ability to make penalty-free withdrawals, degree of creditor protection, and distribution requirements associated with each option.
Come back to learn the basics of 403(b) plans and the unique planning opportunities they present.