Chapter 05: What Is a 401k?

Since its inception in 1978, the 401k plan has grown to be the most popular type of employer sponsored retirement plan in America.

Millions of workers depend on the money that they have saved in this plan to provide for their retirement years, and many employers use their 401k plans as a means of distributing company stock to employees.

Few other plans can match the relative flexibility that 401ks offer. In recent years, several variations of this plan have emerged, such as the SIMPLE 401k and the safe-harbor 401k.

But what is a 401k? And why is it important to have one? We’ll be answering those questions, and more, below.

So far in our retirement series, we’ve gone over a lot of the basics of retirement, like how much you’ll need to retire, how much out of your paycheck you should put away for retirement, how to make a retirement budget, and more. But in Chapter 5, we’ll answer the question of “what is a 401k plan” and show you how it helps millions of people prepare for retirement.

• What Is a 401k Plan?
• Contribution Limits
• Investments
• Distribution Rules
• Loans
• Limits for High-Income Earners
• Why Is It Important to Have a 401k?
• Key Takeaways: What Is a 401k Plan & How Does It Work?
• The Bottom Line

What Is a 401k Plan?

So, what does 401k stand for?

By definition, a 401k plan is an arrangement that allows an employee to choose between taking compensation in cash or deferring a percentage of it to an account under the plan.

The amount deferred is usually not taxable to the employee until it is withdrawn or distributed from the plan.

However, if the plan permits, an employee can make 401k contributions on an after-tax basis, and these amounts are tax-free when withdrawn.

401k plans are a type of retirement plan known as a qualified plan, which means that this plan is governed by the regulations stipulated in the Employee Retirement Income Security Act of 1974 and the tax code.

Qualified plans can be divided two different ways: they can be either defined-contribution or defined-benefit plans.

401k plans are a type of defined-contribution plan, which means that a participant’s balance is determined by contributions made to the plan and the performance of plan investments.

The employer is usually not required to make contributions to the plan as is usually the case with a pension plan.

However, many employers choose to match their employees’ contributions up to a certain percentage, and/or make contributions under a profit-sharing feature.

Types of 401k Plans

There are two types of 401k plans you can have: traditional vs. Roth 401k plans.

With a traditional 401k plan, an employee’s contributions are deduced from their gross income. Your gross income is the amount of money you make before taxes. This means their money will grow tax-deferred. The main benefit of tax-deferred money is that no taxes are due on the money or the earnings until the employee withdraws it, which usually doesn’t happen until after retirement.

With a Roth 401k plan, an employee’s contributions are deducted from their after-tax income. This means their money will grow tax-free and no additional taxes will be due when the money is withdrawn during retirement.

Both are great investment accounts when it comes to saving for retirement, but it’s important to weigh the pros and cons of each so that you can make a decision of which type is right for you.

Contribution Limits

There are contribution limits for 401ks, which is essentially the maximum amount of money an employee can put towards their 401k account. Contribution limits can vary by age and the type of retirement plan someone has.

• For 2022, the maximum amount of compensation that an employee can defer to a 401k plan is $20,500.
• Employees age 50 by the end of the year and older can also make additional catch-up contributions of up to $6,500.
• The maximum allowable employer/employee joint contribution limit remains at $61,000 for 2022 (or $67,500 for those aged 50 and older).

The employer component includes:

• Matching contributions
• Nonelective contributions
• Profit-sharing contributions

Investments

Typically, plan contributions are invested in a portfolio of mutual funds, but can include stocks, bonds, and other investment vehicles as permitted under the provisions of the governing plan document.

If you want to start to invest, you should make a financial plan of which type of investments are right for you. You should also be aware of important investment terms so you can have a better understanding of what it all means.

Distribution Rules

The distribution rules for 401k plans are different from IRAs.

The money inside the plan does grow tax-deferred as with IRAs, whereas IRA distributions can be made at any time, a triggering event must be satisfied in order to withdraw money early from a 401k plan.

As a result, 401k assets can usually be withdrawn only under the following conditions:

• Upon the employee’s retirement, death, disability or separation from service with the employer
• Upon the employee’s attainment of age 59.5
• The employee experiences a hardship as defined under the plan, if the plan permits hardship withdrawals
• Upon the termination of the plan

If you cash out a 401k plan early, you’ll be subject to various consequences and penalties from the IRS. You’ll also have decreased your investment earnings because you’ll have less money in your account to earn compound interest on.

You may also be wondering what happens to your 401k when you quit a job. If you quit a job, you have a couple of options of what to do with your 401k, which include:

1. Keep it with your old employer
2. Roll over to your new employer
3. Roll over into an IRA
4. Retire, if you’re of age
5. Cash out

Required minimum distributions (RMDs) must also begin at age 70.5, unless the participant is still employed and the plan allows RMDs to be deferred until retirement.

Distributions will be counted as ordinary income and assessed a 10% early distribution penalty if the distribution occurs before age 59.5 unless an exception applies.

Exceptions include the following:

• The distributions occur after the death or disability of the employee.
• The distributions occur after the employee separates from service, providing the separation occurs during or after the calendar year that the employee attains age 55.
• The distribution is made to an alternate payee under a qualified domestic relations order (QDRO).
• The employee has deductible medical expenses exceeding 7.5% of adjusted gross income.
• The distributions are taken as a series of substantially equal periodic payments over the participant’s life or the joint lives of the participant and beneficiary.
• The distribution represents a timely correction of excess contributions or deferrals.
• The distribution is as a result of an IRS levy on the employee’s account.
• The distribution is not taxable.

The exceptions for higher education expenses and first-time home purchases only apply to IRAs.

Of course, the majority of retirees who draw income from their 401ks choose to roll over the amounts to a traditional IRA or Roth IRA. A rollover allows them to escape the limited investment choices that are often presented in 401k accounts.

Employees who have employer stock in their plans are also eligible to take advantage of the “net unrealized appreciation” rule (NUA) and receive capital gains treatment on the earnings.

Loans

Plan loans are another way that employees can access their plan balances, but several restrictions apply.

First, the loan option is available at the employer’s discretion; therefore, if the employer chooses not to allow plan loans, then no loans will be available.

If this option is allowed, then up to 50% of the employee’s vested balance can be accessed, providing the amount does not exceed $50,000, and it must usually be repaid within five years.

However, loans used for primary home purchases can be repaid over longer periods. The interest rate must be comparable to the rate charged by lending institutions for similar loans.

Any unpaid balance left at the end of the term may be considered a distribution and will be taxed and penalized accordingly.

Limits for High-Income Earners

For most rank-and-file employees, the dollar contribution limits are sufficiently high enough to allow for adequate levels of income deferral.

But the dollar contribution limits imposed on 401k plans can be a handicap for employees who earn several hundred thousand dollars a year.

For instance, a high-income employee in 2022 can only include the first $305,000 of income that can be considered when computing the maximum possible contributions to a 401k plan.

Employers have the option of providing nonqualified plans, such as deferred compensation or executive bonus plans for these employees in order to allow them to save additional income for retirement.

Why Is It Important to Have a 401k?

We’ve answered “what is a 401k plan and how does it work?”, but what about why it’s important to have a 401k?

There are many benefits of having a 401k is important, such as:

• You get tax benefits: Contributions are pre-tax, so you don’t have to pay taxes on them until you withdraw the money. Your contributions can also put you in a lower tax-bracket since they’re not counted as income. This can cause your tax bill to be smaller. Your savings will also grow tax deferred, which means your earnings will get earnings.
• You get company match benefits: Many employers will match employee contributions, which is basically like free, tax-deferred money in your pocket.
• You earn compound interest: One of the biggest benefits of a 401k is that you earn compound interest on your money, so basically the earlier you start investing, the more money you’ll make.

Key Takeaways: What Is a 401k Plan & How Does It Work?

• A 401k plan is an arrangement that allows an employee to choose between taking compensation in cash or deferring a percentage of it to an account under the plan.
• 401k plans are a type of defined-contribution plan, which means that a participant’s balance is determined by contributions made to the plan and the performance of plan investments
• There are two types of 401k plans you can have: traditional vs. Roth 401k plans.
• There are contribution limits for 401ks, which is essentially the maximum amount of money an employee can put towards their 401k account
• a triggering event must be satisfied in order to withdraw money early from a 401k plan

The Bottom Line

401k plans will continue to play a major role in the retirement planning industry for years to come. In this article, we have only touched on the major provisions of 401k plans. For more specific information on the options available to you, check with your employer and plan provider.

It’s imperative to have a solid understanding of what a 401k is and how to get more out of your 401k in order to set yourself up for future financial success.

Now that we’ve answered the question of “what does 401k mean?”, you can move onto Chapter 6 of our series, which covers more details about 401ks vs. IRAs.

Source: IRS 1, 2, 3, 4

This is for informational purposes only and should not be construed as legal, investment, credit repair, debt management, or tax advice. You should seek the assistance of a professional for tax and investment advice.

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