The Ins and Outs of 401(k) Plans

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Many people are confused about the different types of retirement savings plans.  The confusion grows when they are faced with such decisions as which plan to place their money, how much, and when they can draw their money out during retirement.  Traditional or Roth?  401(k) or 403(b)?  The questions concerning retirement savings plans can be overwhelming.

What Is a 401(k)?

A 401(k) allows workers to save and invest part of their pay before taxes are taken out.  The taxes are paid when the money is ultimately withdrawn from the savings account during retirement.  The name 401(k) actually refers to the section of the tax code that governs these savings accounts.  

Before the 1980s, most employers had offered pension funds to their employees for retirement.  However, as the years headed toward the turn of the century, most employers had replaced their pension plans with 401(k) plans.  A pension is a managed fund where the employer pays out a steady income to the retiree over the course of retirement.  Many government employees may still be eligible for a pension.  However, due to escalating pension costs, many employers switched to 401(k)s for employee retirement.

What Are the Advantages of a 401(k)?

The main advantage of a 401(k) is that the investor controls their investments.  Employers may also match a certain percentage of employee contributions.  Many 401(k) plans offer a wide variety of mutual fund choices.  Mutual funds are an assembly of stocks, bonds, and money market investments grouped together based on risk.  Depending on how close an investor is to retirement, the grouping changes to decrease overall risk.  The most popular options are target-date funds that are more aggressive early on in the savings years, but then become more conservative the closer the investor inches toward retirement.

What Are the Disadvantages of a 401(k)?

Although a 401(k) is a wonderful tool to help workers save, there are many restrictions.  When beginning an investment into a 401(k), most employers who match a certain percentage of contributions, will not allow withdrawal of those contributions until an employee is vested in the company.  Vesting is a set time that an employee must work for a company before they are allowed to have access to the payments in their 401(k).  Personal payments are considered immediately vested.  Employers usually require vesting to guard against employees leaving the company early.  With the many complex rules pertaining to withdrawals and penalties, anyone considering withdrawing 401(k) funds before retirement should speak with a qualified individual knowledgeable in tax code.

How Much Money Should an Employee Invest?

The biggest question for many workers is how much to invest.  The simple answer is to invest as much as possible.  We all need money to live, eat, and pay off debt, but at the very least, investing enough to match the company’s contributions.  Not saving what an employer match is like leaving free cash on the table.  Most plans offer matching funds.  According to the Profit Sharing/401k Council of America, the most popular percentage is 3% of an employees salary.

For example, if an employee makes $100,000 per year, 3% saved into a 401(k) plan would take out $3,000.  With an employer matching this amount, the overall invested amount into the plan would be $6,000 yearly.  An employee may add more to this amount, but the company will only match up to 3%.  Since matching amounts vary from company to company, check with an employer about the qualifications for contributions.

What Are the Limits a Person Can Contribute?

The IRS sets contribution limits for any 401(k) account.  For example, for 2017, the maximum amount that can be put into the fund is $18,000.  However, for those age 50 and older who are closer to retirement, they can put in an additional $6,000.

There are numerous rules governing the “phase-out range” pertaining to 401(k) contributions.  

  • For those filing single that are covered by a retirement plan, the phase-out range is $62,000 to $72,000.
  • For married couples who file jointly, if one or both spouses are making contributions and covered by a workplace retirement plan, the phase-out range is $99,000 to $119,000.
  • For married couples who file separately, the phase-out range drops to $0 to $10,000.

What Are the Different Types and Rules of 401(k)s?

The two different types of 401(k)s are Traditional and Roth.  The tax and withdrawal rules differ for each.

  • Traditional 401(k) – Wages are contributed before taxes are taken out which causes the taxable income to drop by the amount contributed.  Income taxes are deferred until the money is withdrawn.  With this type of 401(k), there is no access to the funds before age 59 ½ or if an employee leaves an employer at age 55.  For early withdrawal, there are the usual taxes due, plus and additional 10% penalty.
  • Roth 401(k) – After taxes, money is placed into the account.  No taxes are required to be paid when the money is withdrawn.  This plan allows for increased flexibility and free access to the money invested with no early withdrawal penalty once the investment has been held for 5 years.

How Long Does an Employee Have to Wait to Invest?

Depending on the particular company, investments can usually be made as soon as employment begins.  However, if a company is smaller, an employee may have to wait up to a year before being allowed to enroll in the company’s 401(k) plan.  If this is the case, set up an individual retirement account immediately.  Don’t wait for an entire year to begin saving.

Some Final Tips Regarding 401(k) Investments

  • Contribute at least enough to get the employer match
  • If unsure, target-date funds are a popular way to invest
  • All 401(k)s are safe, even if a company goes under

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