According to recent figures from the Economic Innovation Group, 69 million Americans, or about 56% of the national work force, lack access to a retirement plan through their employers. Perhaps even more seriously, a third of Americans have little or no retirement savings whatsoever. One irony in these statistics is represented by the fact that research consistently demonstrates that one of the most effective ways to ensure adequate retirement savings is participating in an employer-sponsored plan, like a 401(k).
What is a 401(k)?
Let’s cover some of the basics. A 401(k) plan is a type of tax-favored retirement plan that is offered by an employer to the people working for the company. (For nonprofit, educational, and some government entities, the equivalent plan is called a 403(b); most of what we say about 401(k)s also applies to 403(b)s.) The plan is named after the section of the Internal Revenue Code that establishes and governs it.
When you participate in your employer’s 401(k) plan, you contribute part of each paycheck to your account within the plan, via payroll deduction. Once the money is in the account, it can grow and compound tax-free as long as it stays in the plan. This is a tremendous benefit; unlike a regular savings or investment account, where interest earned or increases in value create taxable income for the account owner, the assets in a tax-advantaged account like a 401(k) are able to compound and grow at a faster rate, since none of the increase is taxed. Over time, such tax-free growth can add up to significant amounts of money available to fund retirement, when you are no longer earning a regular paycheck.
And speaking of contributing to the account, one of the greatest advantages of a 401(k) is that many employers offer a matching contribution. In other words, for every dollar of your own that you deposit in your 401(k) account, your employer will match a percentage of that dollar. This opportunity for “free money” is unique to employer-sponsored plans like the 401(k). Each employer sets their own matching percentage and also the requirements for how much the employee must contribute in order to receive the matching employer contribution.
How does it work?
One of the other advantages of a 401(k) plan over individual retirement plans is that you are typically allowed to make larger annual contributions to a 401(k). For example, in 2023, the maximum contribution you can make to an individual retirement account (IRA) is $6,500 ($7,500 if you are age 50 or older). By comparison, the 2023 limit for 401(k) contributions is $22,500 ($30,000 for those 50 and older). And by the way, that is just the limit for how much you can contribute as an employee; including the employer match, the total limit for contributions to a 401(k) plan in 2023 is $66,000 ($73,500 for those age 50 and older). These higher limits are especially important for those who may have fewer years until retirement and need to put away as much as possible on a tax-advantaged basis.
There are two types of 401(k) plans: traditional and Roth. Most employers who offer a 401(k) will allow a choice between the two options. With a traditional plan, your contributions to the account are considered pre-tax; they provide a deduction to your taxable income for the year. When you begin withdrawing money from the account in retirement, the funds you withdraw each year are considered taxable income. Once you reach a certain age (72–75, depending on your year of birth), a traditional 401(k) has required minimum distributions (RMDs): the amount you are required to take out of the account each year. This will be taxed as ordinary income.
Roth 401(k)s work a little differently. First, the contributions you make are after-tax; they do not reduce your taxable income for the year. The growth within the plan is still tax-free, however, and when you begin withdrawing funds in retirement, the withdrawals are not considered taxable income. And, beginning in 2024, Roth 401(k)s have no RMDs; you can leave the money in the plan as long as you want. If the plan passes to your spouse upon your death, your spouse can also leave the funds in the plan if they are not needed for income. If the plan passes to your children, however, they will be required to withdraw the funds over a period of no longer than 10 years.
What if I leave my employer?
If you leave your place of work, you may be able to leave the funds in your plan, if your employer’s plan permits that. You may also take a distribution from your plan, but you may incur taxes and possible penalties by doing so. You may also have the option to take your contributions to your 401(k) account with you in the form of a rollover—either to an IRA or to your new employer’s 401(k), if they offer one. If your former employer made matching contributions to your account, you may forfeit some or all of these funds, depending on the vesting schedule of the plan. Many plans allow you to be fully vested after three years; others require a longer term for full vesting.
Things to be careful of
There are a few things to watch out for if you are participating in a 401(k) plan. Probably the most important one is to avoid pulling money out of the plan early. Remember, the plan is intended to help you save for retirement, when your sources of income may be limited. The IRS imposes a 10% penalty for withdrawals from the plan prior to age 59 ½, unless you are making a withdrawal for a qualified purpose. Also, you will owe taxes on the amount withdrawn. It’s important to understand that your 401(k) should not be used as an emergency fund. Though you may be able to tap it under certain emergency circumstances, it will work best for you if left alone and allowed to grow until retirement.
You should also exercise good judgment when deciding how your 401(k) funds will be invested. This is where a fiduciary financial advisor can be of tremendous help in matching your investments with your retirement goals, your tolerance for risk, and your overall financial plan.
At Mathis Wealth Management, our goal is to help our clients create effective, individualized strategies for funding their retirement and meeting other important financial goals. And our fiduciary standard of care requires us to place the client’s best interests first, in everything we do. To learn more about our comprehensive retirement planning services, please visit our website.
Disclosure: Diversification is an investment strategy that can help manage risk within a portfolio, but it does not guarantee profits or protect against loss in declining markets. All investing involves risk and there is no guarantee that any strategy will ultimately be successful.
