What Is a 401(k) Retirement Plan and How Does It Work?
A 401(k) plan is a good way for U.S. workers to save for retirement on a tax-advantaged basis.
A 401(k) plan, named after the IRS tax code section that details 401(k)s, is an employer-sponsored retirement plan that enables career professionals to save money for their post-working years in a tax-deferred manner. Once a worker retires, any withdrawals from a 401(k) plan are taxed by the IRS.
401(k) plans were designed to be an option, if not take over for, company pension plans. Known as “defined contribution” plans, 401(k)s were considered less expensive for companies to run, and that paved the way for 401(k)s to generally supplant defined benefit-based pension plans.
How 401(k) Plans Work
With 401(k) plans, workers are squarely in the driver’s seat in making decisions on key issues, like contribution rates, investment choices, and 401(k) plan withdrawals. The plan participant decides how much of their paycheck should be steered towards a 401(k) plan, dependent on IRS contribution limits.
Operationally, 401(k) plans are managed by the employer, also known as the plan sponsor. The employer decides the type of 401(k) workers use, what investments workers can choose for their plan, and what investment management firm will run the investment side of a 401(k) plan.
All an employee has to do is sign up for a 401(k) plan with their company (usually the first day or so on the job), choose their contribution levels and their investment vehicles, and the employer takes care of the rest. It’s a good idea to talk to a financial advisor first, before making any 401(k) plan investment selections.
401(k) Investment Categories
Typically, 401(k) plans offer the following types of investments for plan participants, with the average 401(k) providing between eight to 12 investment categories:
- Stocks: In general, individual stocks offered are limited, usually to the company’s own stock. If a 401(k) plan offers a broker account, the plan may offer more individual stocks.
- Stock mutual funds: Companies usually offer a variety of stock funds or exchange traded funds, including large-cap stock funds, small-cap stock funds, value funds, international or emerging market funds and life stages funds, among other fund categories.
- Bond mutual funds: To preserve stability and offer plan participants some asset protection, companies usually offer bond funds to 401(k) plan participants. Types of bond funds include U.S. Treasury bond funds, corporate bond funds, municipal bond funds and money market funds.
- Variable annuities: Some companies also offer variable annuities to plan participants. Annuities offer regular payments to workers after they make an upfront payment. Variable annuity payments are usually paid out once the annuitant reaches retirement age.
- Real Estate: Some Companies like Sol Mar REI, LLC., offer various options for secured-predictable returns with monthly payments to the retirement plans.
Selecting the right blend of investments is job one for 401(k) investors. You’ll need to take the following factors into consideration when you make your 401(k) plan picks:
- Your age: The younger you are, the more risk you can take (as you’ll have more time to recover if your investments don’t perform well.) Conversely, older plan participants may want to be in what Wall Street calls “capital preservation mode,” and choose more-conservative investments, like bonds, to protect the money they’ve already accumulated in their 401(k) plan.
- Your retirement goals/time horizon: You’ll also want to factor in your lifestyle goals and your approximate retirement age. For example, if you plan to retire early at age 50, you’re going to need more money, and thus may fill your 401(k) investment account with more-aggressive investments, like growth stocks and small-cap stocks, which offer more reward — and more risk.
- Your risk tolerance: In plain terms, risk tolerance is the amount of investment risk you can take and still sleep at night. If you get anxious about having too many stocks and stock funds in your portfolio, for example, you’ll want to balance things out by including more-conservative investments like bonds and money market funds.
Taxes play a significant role in 401(k) plans — mostly to the benefit of plan participants.
Retirement investors fund their 401(k)’s with pre-tax cash. That means the money you place in your 401(k) account is removed from your paycheck before taxes are taken out. That can be a “good news and bad news” scenario, as you will curb the income you eventually pay taxes on, but it will reduce your take-home pay. Most 401(k) plan investors eventually don’t miss the deductions, even if they hike their contributions by a percentage point or two.
When it comes to taxes and 401(k) plan withdrawals, know the rules.
By and large, 401(k) plan participants can take withdrawals penalty-free at age 59-and-a-half. The IRS doesn’t actually require 401(k) plan investors to take plan withdrawals until age 70-and-a-half. You won’t pay taxes on your 401(k) plan proceeds until cash is taken out in retirement, with the IRS taxing withdrawals at the plan participant’s ordinary income tax rate. Taxes will continue to be taken out every time you make a withdrawal from your 401(k) plan going forward.
If you take money out before age 59-and-a-half, you’ll pay a price for doing so. The IRS charges a 10% penalty for taking cash out of a 401(k) plan early. That amounts to 10% of the total amount taken out, and cuts into your total 401(k) plan proceeds.
Thus, taking money out of a 401(k) plan early is generally a bad idea, both for tax and plan-accumulation reasons.
Traditional 401(k) Plan Vs. Roth 401(k) Plan
Taxes also factor into the main differences between a Roth 401(k) plan and a traditional 401(k) plan.
In general, a Roth 401(k) plan is a company-sponsored retirement savings account that an employee funds with after-tax dollars. If you believe you’ll be in a higher tax bracket in retirement, a Roth 401(k) can be a real money saver.
The biggest differences between the two 401(k)s — which otherwise are similar — is that Roth 401(k) plan contributions are made with after-tax dollars, and plan withdrawals are not taxed in retirement, as you’ve paid taxes already on your 401(k) plan proceeds.
What Are the Benefits of a 401(k) Plan?
The primary benefit with 401(k) plan is the amount of money you can earn for retirement on a tax-advantaged basis, especially if you start early, and especially if your employer offers a matching contribution (usually up to 6% of plan proceeds) to your 401(k) plan.
In general, the earlier you start contributing to your 401(k) plan, the earlier compound interest goes to work for you.
Think about it. Early-bird investors who contribute anywhere from $100 to $500 per month for 30 or 40 years are well on the way to a financially secure retirement. That’s because at ages 25 or 30, the numbers are heavily in your favor.
Let’s say you invest $100 per month today. Here’s how long it will take to become a “401(k) Millionaire” in doing so:
- A 4% return on your 401(k) investment will make you a millionaire in 89 years.
- A 6% return will make you a millionaire in 66 years.
- An 8% return will make you a millionaire in 53 years.
- A 10% return will make you a millionaire in 45 years.
Double or triple that investment and you can see how fast your 401(k) money will go, and how high it will climb.
401(k) plans offer additional benefits, as well. These five benefits are at the top of the list:
- Easy to save: 401(k) plans make it very easy to save for retirement. Plan participants can have their plan money automatically deducted from their paycheck — it doesn’t get much easier than that.
- Tax benefits: 401(k) plans are tax friendly, as well. Since contributions roll out of your paycheck before taxes are taken out, your taxable income is lower and you wind up paying less in taxes to Uncle Sam.
- Automatic payroll deduction: Having your 401(k) plan contribution taken out automatically makes it easy to save for retirement. It’s both convenient and efficient, and allows you to fund your 401(k) plan with minimum effort.
- Company match: Employers who offer a matching contribution are a 401(k) plan participant’s best friend. It’s free money towards your retirement and definitely helps your plan assets grow on a regular basis.
- Access to financial education tools: Many companies offer investment tutorials, classes, online learning programs, and other financial learning opportunities that are designed to make you a smarter 401(k) plan investor. Take advantage of as many learning opportunities as you can — being smarter about money and finance can set the table for smarter money moves that go beyond your 401(k) plan.
401(k) Plan Contribution Limits
With 401(k) plans, employees can sock away up to $18,5000 annually in tax-deferred investment accounts for employees under 50 years of age. Employees 50-and-older can contribute an additional $6,000 in “catch-up” money in 2018, according to the IRS. That means the money you contribute reduces your taxable income. Plus all the earnings grow tax-free until withdrawal.
Better yet, more than about 70% of all employers match investments, with about $0.50 on your dollar. That means if you contribute 3% of your salary ($2,000, for example) then your employer may match that 3% contribution, and kick in $2,000 to your 401(k) plan.
When it comes to your 401(k) plan, the value of good investment research is priceless.
Consequently, study up on finance and investments, and make sure you read every word of the 401(k) packets, brochures, online and mobile messages and emails that your employer provides. The payoff in doing so is big, particularly as 401(k)s continue to benefit from a booming stock market.
Additionally, know your 401(k) plan will do well if it’s managed well, as your 401(k) is unlikely to produce maximum returns running on autopilot.
To succeed, you need a sound investment strategy, one that reflects your retirement needs, time horizon, and risk-tolerance level. Take the time to manage your funds wisely, and watch your nest egg grow with your 401(k) plan.
Should you need assistance on any of these issues, feel free to contact for a no cost consultation.