When we meet with new or potential clients, we typically ask a lot of questions about their financial situation. This isn’t simply because we are nosey, but rather because in order to give proper advice we need to see the whole picture. Oftentimes, the person that we are meeting with has access to a 401(k) plan (or 403(b) if they are a government or non-profit employee) but they know very little about it. They may know that they are contributing a portion of their paycheck to the plan but are often unsure about all of the other factors. Since this is a frequent occurrence, I wanted to dedicate a post to covering the basics of 401(k) plans.
What exactly is a 401(k) plan? Well, essentially it is a way for you to contribute money towards your retirement directly from your paycheck. 401(k) plans are sponsored by your employer and as such often have lower fees and other benefits that an individual retirement account does not have. Additionally, many 401(k) plans allow for both pre-tax and after-tax or Roth contributions which we will touch on a little later.
How does a 401(k) plan work in practice? It starts by you informing your employer what percentage of each paycheck you would like to go to the plan. That amount is then deposited into your account each pay period and is invested in one of the available mutual funds that you have chosen. The account grows tax deferred and is available for you to spend when you reach retirement. Every 401(k) plan has what is called a “qualified default investment alternative” or “QDIA”. Oftentimes, the investment designated as the plan default is called a “target date fund”. These funds are age-based and designed to be more aggressive when you are younger and slowly grow more conservative as you reach retirement age. If you do not choose an investment from the options available, your contributions will be defaulted into the QDIA. However, the QDIA may not fit your exact investing needs, therefore it is recommended that you seek guidance from the plan financial advisor.
As I mentioned earlier, many modern 401(k) plans offer you two types of contributions to take advantage of: Pre-tax and after-tax otherwise known as Roth contributions. Pre-tax contributions are exactly what they sound like. They are contributions which are withdrawn from your paycheck prior to taxes being deducted. As such, pre-tax contributions have the effect of lowering your taxable income. This can be especially beneficial for individuals who are in a higher tax bracket and looking for ways to reduce their taxes. By making pre-tax contributions, you defer taxes on your contributions and any investment gains until you withdraw the funds in retirement. Since you didn’t pay taxes initially, all withdrawals are taxable to you as ordinary income. There is a catch however in that you may not make withdrawals from your 401(k) prior to retirement unless you wish to face a steep penalty by the IRS. The official “retirement age” for 401(k) withdrawals is age 59 ½. Any withdrawals made prior to that age (with some exceptions) will be assessed a penalty of 10% in addition to Federal and state taxes. The last thing to note about pre-tax contributions is that the IRS requires that you begin taking required minimum distributions or “RMDs” from your account at a certain age. Currently, that age is 72 although that is getting pushed all the way back to age 75 over the next several years.
After-tax or Roth contributions are, in many ways, the exact opposite of pre-tax contributions. As the name suggests, after-tax contributions are withdrawn from your paycheck after taxes have been withheld. That said, they do not have the immediate tax benefit of lowering your taxable income as pre-tax contributions do. However, unlike pre-tax contributions, Roth contributions are not taxable in retirement. Since you paid taxes on your initial contributions, all withdrawals from Roth 401(k) contributions are tax free when withdrawn in retirement after age 59 ½. Much like a Roth IRA, after-tax contributions to a 401(k) may also be withdrawn without paying the 10% penalty. However, investment gains are still subject to taxes and the 10% penalty if withdrawn early. It should also be noted that at least some of your early withdrawal, regardless of how much you withdraw, will be attributed to gains and thus taxed and penalized. Additionally, Roth contributions are also subject to a “5-year” rule. The rule stipulates that in order for withdrawals from a Roth 401(k) to be considered tax free, the contributions must have begun 5 years prior to the withdrawal. This means that even if you are older than the stated retirement age, your withdrawals could still be taxed and penalized if the account is less than 5 years old. For example, if an individual is 62 years old but only started making contributions 2 years ago, their withdrawals would still be penalized despite the fact that they are older than 59 ½. Lastly, thanks to the recently passed SECURE Act 2.0, Roth contributions to a 401(k) are not subject to the RMD rules that pre-tax contributions are.
In addition to the basics of 401(k) plans, many employers also have plan specific rules in place. One such rule is the “Automatic Deferral Election” which automatically enrolls you in the plan at a specified contribution amount. While you are not required to contribute to your company 401(k) many plans do require you to make a conscious choice one way or the other. If you neglect to enroll by a certain deadline, you will be automatically enrolled at the specified contribution percentage (usually 3% of your paycheck) and invested in the QDIA (often the target date retirement fund). The easiest way to avoid this is simply to proactively enroll yourself in the plan and make your desired choices (even if that means you do not want to contribute to the plan at all).
Generally speaking, you are not allowed to take a withdrawal from your 401(k) plan while you are still an active employee of that company. However, there are some allowances for financial hardship and childbirth or adoption if your plan allows for “hardship distributions”. Additionally, any money that you roll into the plan from another employer sponsored plan is also eligible to be withdrawn. Keep in mind that in that case you would still need to pay taxes and potentially a penalty if you are younger than 59 ½. Regarding hardship distributions, the exact situations for which these types of distributions are allowable should be spelled out in your “Summary Plan Description”. If you do not have this document, I would recommend that you ask your HR department or the plan financial advisor for a copy. If you withdraw funds for any of the reasons listed under hardship distributions, you will not be hit with the 10% penalty for early withdrawal.
Lastly, the most exciting benefit of 401(k) plans for employees is the potential for receiving contributions to their account by their employer. Not every plan offers employer contributions, however if they do, they usually fall into one of three categories: Matching, profit sharing, and safe harbor contributions. Employer matching contributions only apply if you are making contributions yourself. In that case, an employer might match a certain percentage or dollar amount. For example, your employer might match 50% of your contributions up to a maximum of 3% of your paycheck. It is important to know what these exact rules are in order to make sure you are getting the most of your employer match. Using the previous example, you would need to contribute 6% of your paycheck in order to receive the 3% match for a total contribution of 9%.
Profit sharing and safe harbor contributions are different in that they are both considered “non-elective”. This means that you do not need to contribute any of your own money in order to received these types of contributions. Profit sharing contributions are completely at the discretion of your employer. As the name would suggest, these contributions are usually based on the company’s profit for the prior year. Depending on how well the company did over the year prior, the amount that you receive could vary and may even be zero. Safe harbor contributions on the other hand are mandatory on the part of the employer. An employer might elect to forgo matching contributions in favor of a safe harbor contribution of 3% for all employees. The reason that they might do this is if they have a small number of highly compensated executives who wish to contribute high dollar amounts to the plan. Normally, this could cause various problems and the government could deem the plan “top heavy”. By offering safe harbor contributions an employer eliminates this issue.
Whether or not you decide to participate in your company 401(k) plan is entirely up to you and should be discussed with your financial advisor. These plans in general can be a great way to beginning building towards a potential retirement. However, knowing and understanding the rules is crucial to making the plan work for you. Make sure that you know what you are doing prior to making contributions!
Thanks for reading this week’s blog post! As always, I have picked a song of the week (which I realize is the only reason that some of you read the blog 😊). Enjoy today’s tune!
The target date is the approximate date when investors plan to start withdrawing their money. The principal value of a target fund is not guaranteed at any time including at the target date.
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal, or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.