What is a 401(k) Plan?
A 401(k) is an employer-sponsored retirement plan. Its name comes from Section 401(k) in the Revenue Act of 1978. This allows employers to offer tax-advantaged savings accounts to employees. Employees can set up contributions from their paychecks, and most employers offer contribution matching up to a certain amount.
As money piles up in a 401(k), you can start putting it to work for you. The 401(k) plan providers offer different investment options. And the sooner you start investing, the more money you’ll have in the future. So let’s look at some common 401(k) questions…
401(k) Employee Contribution Limits for 2020 and 2021
If you have an individual retirement account (IRA), you’re probably familiar with contribution limits. The Internal Revenue Service (IRS) determines a maximum amount an individual can contribute to their 401(k) plan(s) each year.
For 2020, the IRS announced a couple of changes for 2020. Included in these changes is an increase in employee 401(k) contribution limits.
- Total employee contribution (under 50 years of age) – $19,500
- Total employee contribution (over 50 years of age) – $26,000
- This includes an increased “catch-up” contribution of $6,500
The 401(k) contribution limits for 2021 remain the same as 2020.
401(k) Employer Contribution Limits and Rules
If your employer offers contribution matching, they also have a contribution limit. It’s the lesser of:
- 100% of employee compensation, or
- Employee under 50 years of age – $57,000
- Employee over 50 years of age – $63,500
- Employee under 50 years of age – $58,000
- Employee over 50 years of age – $64,500
On top of that, employers that offer matching have different rules. And 401(k)s are contribution-defined plans. This means the amount your employer will contribute is predefined. You can find details in your plan’s summary description.
Employers use a formula to determine how much to contribute. For example, one company might offer a half match of up to 6% of your salary. So if you make $100,000 and contribute $4,000 (4%), the company chips in $2,000. That’s half of your 4% contribution. Or if you contribute $6,000 (6%), the company puts in $3,000. This would max out the company’s match for the year. If your employer offers a full match, they would contribute $6,000 as their max. Although, you can still contribute more up to the total employee contribution limit. You can always consult your plan summary or HR department with any questions you have about your employer’s contributions.
A company’s 401(k) contribution match is free money. So it’s good to take full advantage. Whenever possible, try to max out your employee match. The money you put in is also tax-advantaged. Let’s look at that next…
401(k) Taxes – Traditional vs. Roth
Many employers offer both traditional and Roth 401(k) plans. And sometimes you can contribute to both (without exceeding the limits listed above). However, employer contributions can only go toward a traditional 401(k).
There are distinct tax differences between traditional and Roth 401(k)s. A traditional 401(k) has pretax contributions. These are taken out of your paycheck before taxes are deducted. This benefit reduces your taxable income. For example, if your income is $50,000 and you contribute $5,000, your taxable income is $45,000. You don’t pay tax on the $5,000 until you withdraw the money.
On the other hand, a Roth 401(k) has post-tax contributions. While you won’t get a tax deduction up front, your withdrawals are tax-free because you already paid them. However, not every employer offers a Roth 401(k). Also with both Roth and traditional accounts, your investment income is tax-advantaged.
Investing Your 401(k) Savings
It’s important to understand where your investments are going. The person in charge of your account may not always care about your best interests. Here are some tips to know so you can be involved in your 401(k) investments.
Look at the fees. Here’s an example: You invest $5,000 for 35 years with an annual 9% return. When you retire at 65, your 401(k) portfolio will be worth close to $1.1 million. That’s a lot of money! But let’s say you have an annual fee of 1%. Now you’re losing out on close to $200,000 of that $1.1 million.
These are also known as expense ratios. In the example above, the expense ratio is 1%. That means 1% of the fund’s assets are used to cover costs, such as operating, management and advertising expenses. Choosing a fund with a lower fee might save you a lot in the long run.
Practice diversification. Have you heard the saying, “Don’t put all your eggs in one basket?” That’s the idea here. Diversification is a method of reducing risk by putting your money into a mix of stocks, bonds and other investment funds. This way, if an event crashes one area of the market, you’ll have other investments that continue to grow unaffected by it. While this method is not guaranteed to get the highest return, it’s usually the best way to reduce risk and reach your long-term goals.
If you’re trying to figure out how to allocate your investments, an easy way is to follow the 110 rule. Take your age and subtract it from 110. That percentage is what you can invest into stocks, and the rest is invested into bonds. For example, if you’re 35 years old, subtract 35 from 110. The answer of 75 is the percentage of investments that should be stocks. The remaining 25% should be invested into bonds. Although, this is just a simple rule of thumb. Every situation is different and you can contact a financial expert for specific advice.
To learn more about investing, you can also check out our Investing 101 page.
401(k) Required Minimum Distribution
A required minimum distribution (RMD) is a mandatory amount of money you must withdraw. Depending on the plan, you must take an RMD by April 1 the calendar year after you either turn 70½ or you retire, whichever is later. Unlike IRAs, both traditional and Roth 401(k) plans have RMDs.
What to Do with an Old 401(k) Plan
When you leave one job for another, you have a few options for your 401(k).
Take the money
- You will have to pay income tax on the amount withdrawn.
- If you’re under 59½, you will also have to pay the 10% early withdrawal penalty.
Leave the money
- You will not be able to contribute any more to this plan.
- If you leave 401(k) plans behind with former employers, you could end up forgetting about them.
Transfer the money to your new 401(k)
- Check with your employer to see if this is an option.
Rollover to an IRA
- Your funds will maintain their tax-deferred status.
- IRAs can have a greater range of investment options.
- For more information on rolling your 401(k) to an IRA, check out: What is an IRA Rollover?
If you have any questions about retirement accounts, please leave a comment below. You can also sign up for our free e-letter below. It’s packed with retirement and investing insight.
About Amber Deter
Amber Deter has researched and written about initial public offerings (IPOs) over the last few years. After starting her college career studying accounting and business, Amber decided to focus on her love of writing. Now she’s able to bring that experience to Investment U readers by providing in-depth research on IPO and investing opportunities.