What is a 401k

What is a 401k

There are several options available to save for retirement. Broadly speaking, retirement savings can be categorized into defined-contribution plans such as 401k and IRAs and defined-benefit plans. Both categories are exactly what they sound like. A pension plan is a defined-benefit plan, where your employer pays you a defined amount each month post-retirement. A defined-contribution plan, on the other hand, is where employee (and in some cases, employer) makes a set contribution from each paycheck into a retirement account.

In case of a traditional pension account, the onus of investment and growing the investment is with the employer. Advances in medical sciences have increased life expectancy, increasing employers’ cost in offering pension plans. As a result of this, and several other factors, many pension plans in private sector are under-funded. Not surprisingly, pension plans are becoming extinct as more and more employers are instead offering a defined-contribution plan, or a 401(k), as you may know it in the United States.

What is a 401(k) plan?

The 401(k) plan is defined in the 401(k) subsection of the Internal Revenue Code. Many private companies provide employees the option to contribute to a 401(k) plan. Employee compensation is deducted from the paycheck before taxation and invested in a retirement plan. Sometimes, an employer makes a proportionately matching contribution, up to a certain limit, to the plan. If your employer makes a contribution, always, always, always, opt into the plan. And here’s why.

Say, you are an employee earning $100,000 a year. Also, assume your employer matches up to 6%, dollar for dollar, of your contribution to the plan. That means if annual 401(k) employee contribution is $6,000 pre-tax, employer will also contribute $6,000. Now your total compensation became $106,000. The company match is like a free bonus you received from your employer. Furthermore, the employee doesn’t pay any taxes on the investment income generated from assets in the 401(k) plan until retirement.

Now, let’s discuss tax savings. If you didn’t make any contribution to the 401(k) plan, you would have to pay taxes on your total compensation of $100,000. For the sake of simplicity, let’s assume a flat tax rate of 30%. Your after-tax compensation would be $70,000. But since you made a $6,000 contribution to your 401(k) plan, you only pay tax on $94,000, netting $65,800 in your bank account, plus your $6,000, and the company match of $6,000 in your 401(k) account.

The $12,000 in your 401(k) account is not tax-free. It is only tax-deferred. This only means that you will pay tax on the money in your 401(k) when you make withdrawals, hopefully, post-retirement. Usually after retirement, most individuals will be in a lower tax bracket, and the withdrawals will be taxed at a lower rate than if they had not opted into the 401(k) plan.

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Can you contribute your entire compensation to your 401(k)? No. For 2020, the IRS caps the annual employee contribution to $19,500.

Withdrawal of funds from a 401k

Generally, you may begin to withdraw from your 401(k) plan after the age of 59½ without penalty. If you withdraw before that age, the distribution will be included in your taxable income and you also incur an additional tax of 10%. An early distribution always incurs an additional 10% tax with the following exceptions: death or disability of the Individual Retirement Account (IRA) owner, series of substantially equal payments into the plan, dividend pass-through from an employee stock option program, IRS levy of the plan, rollover to another retirement plan within 60 days of withdrawal, and separation of service after the age of 55.

Required Minimum Distributions

IRS requires a minimum distribution to be taken from the 401(k) plan when you reach the age of 70½. Use this worksheet https://www.irs.gov/pub/irs-tege/uniform_rmd_wksht.pdf to calculate the minimum distribution for your traditional IRA unless your spouse is the sole beneficiary of the plan and is more than 10 years younger than you. This worksheet is as of January 2019. For a more recent version, please visit the IRS website.

Investment options in 401k

The biggest drawback of 401(k) plans is that the onus of investing and growing your retirement assets is on you, the individual and not your employer. Most employers offer a range of investment products for individuals to choose from. However, not all options are straightforward and some can be difficult to understand without a deeper dive in the fund literature. Key factors to consider are asset allocation, benchmark tracking and expense ratio. More on this later!

Aligned with the growing popularity of target-date funds, many IRA providers have begun to offer target-date retirement mutual funds. A link to target-date funds can be found here.

Happy investing!



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