The Ins and Outs of 401(k) Plans

It is not often that a section of the U.S. Internal Revenue Service (IRS) code becomes part of the common parlance. 401(k) plans–named for the provision in U.S. tax law that made these plans possible–have become an important part of the retirement discussion. Read on to learn about these savings plans and the unique features they possess.

What is a 401(k) Plan?

A 401(k) plan is a defined contribution plan that many employers offer their workers to help them save for retirement.

In practice, employees will contribute a percentage of their monthly earnings to this plan. These monies will be invested in one or more of the investment vehicles that are offered through the employer, usually an assortment of mutual funds with varying degrees of risk and reward. (Employers will usually contract with an investment house or financial services firm to provide these options.)

Different companies offer various perks, such as matching benefits (see below). What is true for all options, however, is that the money you have contributed is yours. If and when you leave your place of employment, your savings transfers with you.

You can use TipRanks’ 401(k) calculator to understand how your account will grow over time based on your contributions and employer matches. Note that this calculation does not take into account whether you are using a Traditional or Roth 401(k) plan (the distinction between the two is described below).

What are the Advantages of a 401(k)?

There are a few advantages that make this a worthwhile perk of any employment opportunity.

Employer contributions: Many employers will match employee contributions, either in whole or in part. For instance, if your employer offers a 100% matching benefit, every dollar that you contribute will automatically double. In other words, if you decide to contribute 5% of your monthly salary to your plan, 10% of your overall salary is saved and invested.

The way it works, a $250 monthly contribution morphs into $500 a month of savings. This can help you quickly ramp up your funds for retirement. (Even if your employer only offers a 50% match in the above example, this is an extra $125 a month, or $1,500 a year.) These monies will grow beyond the contributions from your paycheck and your employer, respectively, as the funds will be invested in interest-bearing and wealth-generating accounts.

It is also important to consider that the amount of time you need to stay with your employer sometimes influences the amount of employer contributions that you can keep. Known as vesting, companies want to incentivize you to stick around, and so every month you stay at the firm gets you closer to owning all of the monies the employer has contributed to your 401(k). At some companies there is no vesting requirement, while others will require a range of periods of time before you “own” all the monies that the employer has contributed. This is usually between 3 and 6 years, which is the maximum amount of time an employer can require before an employee is fully vested.

Tax obligations: The type of tax benefit depends on whether you have a traditional 401(k) or a Roth 401(k) plan. However, you can either defer your initial tax obligations or enjoy your investment earnings tax free in retirement. (See below for a discussion of the tax implications of both Traditional 401(k) plans and Roth 401(k) plans.)

Automatic contributions: Financial planners will often encourage individuals to automatically make contributions to their savings and investment accounts. This removes the temptation to spend monies on consumption, helping you build-up your savings and wealth in an incremental and consistent fashion. By definition, 401(k) plans automatically transfer monies each month out of your paycheck and into a savings and investment account. This provides a regular and effortless transfusion of capital into your retirement nest egg.

What are the Tax Implications of a 401(k) Plan?

There are both traditional 401(k) and Roth 401(k) plans, which essentially function in the same manner except for one critical difference: when they are taxed.

Traditional 401(k) Plans: For traditional 401(k) plans, any monies contributed from your paycheck will be deducted from your annual tax return. In other words, if you make $60,000 a year and contribute $5,000, your taxable income will be $55,000.

This money remains untaxed, even as it grows. You will not pay capital gains taxes on the monies that are accumulating over time.

However, as the old saying goes, “nothing is certain except for death and taxes.” Eventually, you will begin drawing benefits from your traditional 401(k) plan, which is known as a distribution. You will need to pay ordinary income taxes on the money you withdraw, though the monies that stay in the 401(k) remain untaxed.

Roth 401(k) Plans: For Roth 401(k) plans, the contributions are made after income taxes have been paid. In other words, the money you contribute to your Roth 401(k) will still be taxed.

While Roth 401(k) plans do not receive an immediate tax break, you will enjoy a meaningful long-term benefit. Because the income will have already been taxed, you will not be taxed on these monies again.

Practically speaking, this means that the monies you earn from your Roth 401(k) will not be taxed when you begin taking your distributions. This can be especially meaningful later down the road, when all the monies in your account truly belong to you and not to Uncle Sam.

There are some caveats, however. This tax benefit only applies if you do not withdraw monies before you turn 59.5 and have owned the account for at least 5 years. There are exceptions to this rule if you are suffering from a disability.

Conclusion: It Pays to Play

If given the option to join an employer-offered 401(k) plan, it often makes sense to do so. Aside from potential employer contributions and tax benefits, this vehicle will make saving money for retirement automatic and straightforward.

If your employer does not offer a 401(k) plan or you are self-employed, there are other options that you can pursue to begin saving for retirement such as an Individual Retirement Account (also known as an IRA).

The earlier you start saving for your retirement, the better. Not only will you have more time to make contributions throughout your career, but you will take advantage of the magic of compound interest. In this way, you will truly make your money work for you, even after you stop working yourself.

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