There are various options available to save for retirement, which can assist in achieving your goals. A familiar option for many people is a 401(k) plan provided by their employer. Americans' participation in these plans is increasing significantly. In Q4 of 2022, the average 401(k) balance rose to $107,100. This represents an 8% increase from the previous quarter and a 36% increase from 9 years ago.

Although many people are making contributions to their 401(k)s, you may still have some questions - Like, what exactly is a 401(k) and how does it operate? Keep reading to understand the fundamentals of retirement accounts and how they operate. At that point, determine if it's the appropriate plan for you.

Employers offer a retirement savings plan called a 401(k) to assist workers in saving for retirement. During their employment, employees have the option to deposit a designated portion of their paycheck in their accounts. The deposited funds can be invested in various assets like stocks, bonds, and mutual funds. The investments you can make usually depend on your employer's plan. Also, it's common for companies to match your contributions up to a certain percentage of your income. A 401(k) serves as a key element to both retirement planning and wealth management. 

Traditional vs. Roth 401(k)

When you are setting up your 401(k), you will need to choose whether you want to make pre-tax contributions, after-tax contributions, or both.

With a traditional 401(k), you can contribute pre-tax dollars, which refers to the funds being taken out of your paycheck before taxes are deducted. By using this option, you can increase the portion of your earnings that you contribute and lower your taxable income at the same time. When you withdraw funds during retirement, you will need to pay taxes on the amount. This is because the taxes were not paid when the money was contributed to the account.

A Roth 401(k) functions in the opposite manner. When you contribute, your taxes are paid first and after that, your money will grow without any taxes. During retirement, you won't need to pay any taxes on the money you withdraw. Contributing to a Roth 401(k) will not lower your current taxable income. However, it can help you avoid paying more taxes during retirement. Less tax-efficient investments like actively managed funds and taxable bonds could be well-suited for a Roth account. Choosing a Roth account can be beneficial if you anticipate being in a higher tax bracket during retirement as it could assist you in saving money.

How does a 401(k) work? 

An employer usually establishes and sponsors a 401(k) plan. The retirement savings plan is designed to incentivize employees to save by providing tax benefits and, in some cases, matching contributions. Businesses that decide to provide employer-sponsored retirement plans are required to meet the minimum standard set by the Employee Retirement Income Security Act of 1974, which also provides federal protection for these plans.

You have the option to designate a portion of your salary to a 401(k) plan through payroll. There are limits on the amount you can contribute annually. Starting from 2023, individuals can contribute up to $22,500 annually, and those who are age 50 and above can make an extra catch-up contribution of up to $7,500.

There are withdrawal rules with 401k plans. One thing to keep in mind is that when you make withdrawals, the IRS can withhold 20% of taxes without you having to take any action. If you withdraw $10,000, you will receive only $8,000. When you file your tax return, you may receive a refund if your withholdings and liabilities are reconciled. 
If you withdraw money early, there will be a 10% penalty fee. In our example, if you withdraw $10,000, $1,000 will be deducted as an early withdrawal penalty and you will receive $7,000.

A few exceptions apply. Some plans may permit withdrawals once you turn 55, but only if you have left your employer during the current calendar year. The exception, called the “rule of 55,” only applies to 401(k) plans that are currently active and does not apply to plans from past employers. Furthermore, you might qualify for penalty-free early withdrawals in the event of financial hardship.

Required minimum distributions

The IRS has a requirement that mandates taking money out of your account at some point to avoid keeping tax-advantaged investments in your 401(k) indefinitely. Starting in tax year 2023, you are required to take withdrawals beyond the age of 73. If it is 2033 or later, the minimum age requirement for withdrawals increases to 75. Each year, there is a minimum amount of money that you must withdraw known as a required minimum distribution (RMD). The amount you need to withdraw is determined by a calculation that takes into account your overall account balance and life expectancy. 

If you fail to take the required distribution or withdraw an insufficient amount, you may be subject to a 25% excise tax (which was previously 50%) on the undistributed amount. If you correct your mistake promptly, the tax will decrease to 10%. Additionally, it is worth noting that from 2024 onwards, Roth 401(k)s will no longer require RMDs.

Contribution matching

Some employers provide matching contributions as an additional motivation for saving. Your employer might match the amount you contribute to your retirement savings by giving an equal amount, or they might match a percentage of your salary.

Vesting

In relation to your 401(k), the term "vesting" pertains to the ownership of the funds. The vested balance refers to the amount that you would retain if you were to leave your employer. The money you contribute to your 401(k) is vested from the first day, meaning you have complete ownership and entitlement to the funds. Keep in mind that your employer's matching contributions may vest gradually over a period of several years. This means that if you leave the company before the vesting period is complete, you may have to return a portion of the matching contributions.

401(k) loans

If your employer allows it, you can borrow against the value of your 401(k), which is another advantage of having one. With a 401(k) loan, you can borrow a maximum amount of $50,000 or up to 50% of your vested balance, whichever is less. You must repay the loan along with the interest within a period of five years. If you're using the money to purchase a primary home, you may be eligible for extra time.

When you borrow from your own 401(k), there is no need for a credit check and the loan is not reported to credit bureaus since you are borrowing from yourself. You also have to pay interest on the money you borrow from the account. Although borrowing from your 401(k) may come with benefits, it is important to weigh the potential drawbacks. This includes the possibility of missing out on significant returns if the stock market is performing well. Also, if you quit your job while you still have an outstanding loan, you might be required to repay the entire amount immediately. If you fail to repay your 401(k) loan as per the agreed-upon schedule, you may have to pay income taxes and a 10% penalty on the remaining balance.

401(k) contribution limits

There is a limit to the yearly contribution you can make to a 401(k). From time to time, the limits are modified to accommodate increases in the cost of living. For example, the maximum you can contribute to a 401(k) for tax year 2022 is $22,500. 

Moreover, individuals who are at least 50 years old can make extra "catch-up" contributions worth $7,500 in 2023. The contribution limits are identical for both traditional and Roth contributions.

Please note that the contribution limits mentioned are specifically for the amount of money that you contribute personally to your 401(k). The employer contributions do not contribute to the mentioned totals.

To avoid penalties, you must remove any funds that exceed the annual contribution limit from your 401(k) by the tax filing deadline of the next year. (This applies only to your contributions, by your employer matches.) If you withdraw excess contributions before the deadline, they will be included in your gross income for that year. If you don't withdraw the money, you will be taxed twice on the extra amount - once when you deposit it and again when you withdraw it. 

401(k) Alternatives

If your employer doesn't offer a 401(k), you cannot contribute to one, even if you want to. Not having access to a 401(k) doesn't necessarily imply that you have no options available. There are other types of retirement and investment accounts that can help you increase your wealth.

  • Solo 401(k):  A solo 401(k) may be an option for saving for retirement if you're self-employed and do not have any employees. The contribution limits of this structure, which resembles a traditional 401(k), are higher because you can make contributions as both an employee and employer.

  • Individual Retirement Arrangement (IRA): You can open these retirement plans on your own, and they function similarly to 401(k)s. There are different types of IRAs, including traditional and Roth IRAs. There are also IRAs specifically for self-employed individuals and business owners. These accounts have different annual contribution limits. Earned income is needed to contribute to an IRA, but there may be exceptions if you are married and your partner works.

  • Health Savings Account (HSA): If you are enrolled in a health plan with a high deductible, it's possible that you also qualify for an HSA. Once you reach age 65, you can use the funds from these investment accounts for purposes other than paying for qualifying medical expenses, even though they are meant for that originally and use pre-tax dollars. In 2022, the maximum annual contribution for self-only coverage is $3,650, and for family coverage, it's $7,300.

  • Taxable Brokerage Accounts: Another option is to open an investment account with a brokerage and personally select your preferred investments. In addition, there is no limit to how much you can contribute. Consult a fiduciary advisor when considering this option for help.

Conclusion: 

Employers commonly provide a retirement savings account known as a 401(k). Utilizing a 401(k) can accelerate your wealth, growth with tax benefits and employer matching as some of its perks. Understanding all the rules of 401(k)s is crucial to avoiding penalties that may reduce your investment returns. 

Make sure to explore all your available retirement savings options and create a plan to begin saving, regardless of whether you have access to a 401(k) or not. Investing a portion of your earnings is necessary to reach your retirement goals. Request financial planning advice from a CERTIFIED FINANCIAL PLANNER™. 

About William Bevins CFP CTFA

William Bevins is a CERTIFIED FINANCIAL PLANNER™ and wealth advisor serving Middle Tennessee. His practice focuses on writing financial plans, wealth management, offering advice, and building suitable investment portfolios for individuals, small to medium-sized businesses, and family offices. He may be contacted by email at [email protected].