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A 401(k) plan is a qualified retirement plan sponsored by an employer for the benefit of its employees. An employer may offer this type of defined-contribution plan at the workplace to enable employees to save for retirement.
The 401(k) plan is a tax-advantaged account. That means that I don't have to pay taxes on capital gains, dividends, or interest while I am saving and investing money inside this type of account. My investments grow tax-free until I withdraw money in retirement.
I also get a tax break when I make contributions (unless I contribute to a designated Roth 401(k) account). The amount of taxable income reported by the employer does not include these contributions, aka elective deferrals. So, contributions to a 401(k) plan lower reported income and income taxes.
If I contribute to a designated Roth account within a 401(k) plan, I don't receive any special tax benefits in the year I make the contribution. However, my money can grow tax-free plus I can withdraw the money tax-free in retirement.
The IRS has set limits on 401(k) plan contributions. For traditional and safe harbor plans, employees can make elective deferrals of up to $18,000 in 2015 plus $6,000 in catch-up contributions for those 50 and older. Employees participating in SIMPLE 401(k) plans can contribute up to $12,500 plus $3,000 in catch-up contributions.
In total, annual contributions from the employee and the employer in 2015 can not exceed $53,000 or the employee's income, whichever is less.
Employers frequently match their employees' contributions to their 401(k) accounts to encourage saving for retirement and share profits.
The most common match formula is 50 cents for each dollar up to 6% of pay, according to U.S. News & World Report. In this scenario, if I earn $50,000 annually and contribute 6% of my pay to a 401(k) plan, my employer contributes $1,500 to my retirement account.
Some employers do not offer matching contributions and many follow a vesting schedule. To fully understand how a 401(k) match is designed, study plan documents and talk with the human resources or employee benefits' representative at the workplace.
Types of 401(k) Plans
According to the IRS, there are three types of 401(k) plans: traditional; safe harbor; and SIMPLE. Each type has a different set of rules, pertaining largely to employers' contributions.
- Traditional 401(k) Plan
A traditional 401(k) plan allows employees to make contributions through payroll deductions; that is, money goes straight from my paycheck to my employer-sponsored retirement account. These contributions are considered pre-tax elective deferrals, meaning that I elect to defer income on a pre-tax basis (the contributed amount is excluded from my income).
Employers may make contributions on behalf of all participating employees, contributions based on employees' elective deferrals, or both. These contributions may be subject to a vesting schedule; so, I may need to remain with my employer for a certain length of time in order to take full ownership of my employer's contributions.
My eligibility is based on the plan's rules and IRS guidelines. The IRS dictates that the plan design does not discriminate in favor of highly compensated employees.
- Safe Harbor 401(k) Plan
The Safe Harbor 401(k) plan is similar to a traditional 401(k) plan with a couple of exceptions.
First, the safe harbor plan doesn't have to comply with nondiscriminatory tests pertaining to highly compensated employees. This feature makes this plan attractive to small businesses and small business owners in particular.
Secondly, employees receive a benefit from a safe harbor 401(k) plan. Employers must make contributions either to all employees or matches to employees participating in its plan; and these contributions are fully vested.
- SIMPLE 401(k) Plan
The SIMPLE 401(k) plan is available to small businesses with 100 employees or less.
Similar to the safe harbor plan, the SIMPLE 401(k) plan does not have to pass discrimination tests but does require employer contributions. The employer must make fully-vested contributions that are either 1) a match of up to 3% of each employee’s pay, or 2) a non-elective contribution of 2% of each eligible employee’s pay.
- The Designated Roth Account
You may have heard that about “Roth 401(k)s”; officially, these are not a type of 401(k) plan but a separate account within a 401(k) that holds designated Roth contributions. These contributions are elective deferrals that are included in gross income.
A designated Roth account within the 401(k) is especially attractive to those who want to increase their Roth retirement balances. Unlike the Roth IRA, there are no income limitations.
Steps for Enrolling in a 401(k) Plan and Choosing Investments
If an employer sponsors a 401(k) plan, then employees should learn about the plan at work and how to enroll in the plan.
I may intentionally enroll in a 401(k) plan or become automatically enrolled (unless I opt out of the enrollment). Many employers have initiated automatic enrollments to make sure employees save for retirement.
As part of the enrollment process, I may need to make choices about my participation. Selections may include:
- contribution amounts, often expressed as a percentage of my salary or wages
- annual escalation rates indicating the percentage to increase my contribution each year (generally capped at a certain level, such as 10% of my annual pay)
- investment options, which may include market index funds and company stock
- beneficiary designations
Note that a plan may have automated choices, which can be easily overridden but streamline the process of saving for retirement. For example, an automatic investment option may be a target-date fund aligned with your retirement year.
As part of the enrollment process, I will need to decide how to invest the money held within this account. According to the Financial Industry Regulatory Authority (FINRA), the average plan has 8 to 12 selections though only three are required; some plans are set up with brokerage accounts, giving a broad range of choices.
Consider selecting investments based on an analysis of each choice plus an evaluation of how the option serves the investment portfolio. Consider these elements:
- Expense ratio
- Risk rating
- Asset class
- Category or style
I might choose mutual funds with the lowest expense ratios; or actively managed funds that I believe could outperform low-cost market-index funds. If I have a high tolerance for risk, I could choose investments with higher risk ratings; if I'm conservative, I might opt for lower risk selections.
Finally, if I have significant holdings outside of my 401(k), I might choose investments that diversify my overall portfolio. For example, if I have invested primarily in large-cap funds within my IRAs or regular brokerage accounts, then I might invest in small-cap or international funds within my 401(k) account.
An employer incurs costs to offer the 401(k) plan, including fees paid to plan administrators such as Fidelity, Mercer, and Vanguard.
The Department of Labor breaks these costs into three main categories:
- administrative expenses associated with producing statements, handling legal issues, providing access to plan information, etc.
- investment fees incurred to manage plan investments
- individual service fees associated with participant actions such as borrowing from my 401(k) account
These expenses may be passed along to participants in different ways: a) charged as a flat fee or a percentage of assets; b) embedded in investment fees; and c) charged for specific services rendered to individuals.
The 401(k) plan's annual report, summary description, and statements should contain information relating to investment fees for various options and plan expenses. In addition, BrightScope provides tools to evaluate 401(k) plans and their fees.
Tapping a 401(k) for Cash Before and During Retirement
The money held inside a 401(k) plan is mine, with the exception of non-vested employer matching contributions. However, there are many restrictions associated with taking money out of an account. Still, I can borrow from my account, remove money if I have a hardship, and take withdrawals in retirement.
Guidelines for taking out loans depend on the plan's design and IRS rules pertaining to retirement plan loans.
The IRS allows retirement account owners to borrow 50% of a vested balance or $10,000 (whichever is more), up to $50,000. My plan may specify maximums or even a minimum amount I can borrow.
The interest rate charged on the loan must be “reasonable” or consistent with rates available on the open market. The plan sponsor may choose the prime rate or prime plus 1 or 2 percentage points. Money must be paid back within five years, though home buyers may be able to pay over a longer period of time.
I may be able to borrow for any reason or there may be restrictions, which generally relate to medical, education, or home expenses.
If I don't make payments according to the schedule, the loan may be treated as a withdrawal. Rules pertaining to early distributions apply, generally triggering income taxes on the loan amount and possibly tax penalties. Also, typically, I'll need to settle the loan in full when I leave the employer sponsoring the plan.
If I have an “immediate and heavy” need for cash, I may be able to withdraw money from my 401(k) account. The IRS has strict rules about what constitutes the need for a hardship withdrawal.
The following situations may be considered valid reasons for making a withdrawal under hardship provisions:
- certain medical expenses
- costs relating to the purchase or repair of a principal residence
- payments necessary to prevent eviction from, or foreclosure on, a principal residence
- tuition and related educational expenses
- burial or funeral expenses
Note that 401(k) plan sponsors may or may not allow withdrawals for these or other reasons.
According to the IRS, the maximum amount available to be distributed is generally limited to contributions and “does not include earnings, qualified non-elective contributions or qualified matching contributions.”
Typically, when I reach the retirement age of 59.5 years, I can begin withdrawing money from my 401(k) account without penalty. Likewise, when I turn 70.5, I must make required minimum distributions (RMDs); one exception to this general rule is that I can avoid RMDs if I'm still working for the plan sponsor.
Money withdrawn from a regular, non-Roth account is subject to income taxes at an ordinary income tax rate. However, I don't owe taxes on money withdrawn from a designated Roth account within a 401(k) plan in retirement.
Also, I may be able to arrange for penalty-free distributions before official retirement age by arranging for substantially equal periodic payments over my expected lifetime. I still pay taxes on distributions but skip the 10% penalty.
Account Transfers and Rollovers
When I leave my employer, I may be able to keep my 401(k) in place, orchestrate a rollover to an IRA, or move my money to my new employer's 401(k) plan.
Factors to consider when deciding whether to roll over funds to an IRA or maintain investments inside of a 401(k) plan:
- fees associated with plan administration and investment choices
- investment choices available
- control of plan investments
- restrictions and requirements associated with the account type (availability of loans or hardship withdrawals for example)
- creditor protection with a 401(k) compared to an IRA
- current and future tax consequences of holding investments in IRAs
For IRA rollovers, there are two main types: 1) direct rollover in which I move money directly from my 401(k) plan to an IRA; and 2) 60-day rollover in which I receive money from my 401(k) and reinvest in an IRA within 60 days.
There may be both immediate and long-term tax consequences associated with a rollover to an IRA. Looking at the current tax year, a direct rollover from a traditional 401(k) to a traditional IRA should incur no additional taxes. However, if I decide to do a Roth conversion in future years, the percentage of my investments held in traditional IRAs will impact taxes owed on a conversion to a Roth IRA (weird but true). See this article by Jeff Rose, CFP at Good Financial Cents for illustrations on how traditional IRA holdings can impact the tax calculation of Roth conversions.
Finally, I could cash out the plan when I leave my job with the sponsoring employer. However, that approach typically involves paying taxes and possibly tax penalties. It's likely I'll want to maintain the tax-advantaged status of my investments. See this Fidelity article for a detailed discussion of pros and cons of various ways to deal with a 401(k) at a former employer.
My employer-sponsored 401(k) plan must follow IRS rules to maintain its qualified status and protect tax benefits provided to employee participants. However, certain plan features that are allowed under IRS guidelines may not be implemented by my plan sponsor; for example, my plan may not allow designated Roth accounts, catch-up contributions, loans, or even hardship withdrawals. Key information should be contained in plan documents and communicated to employees.