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What Is a 401 K Plan?
A 401 K plan is named after a section of the U.S. Internal Revenue Code, it is a defined-contribution retirement account provided to employees by their employers.
Through automatic payroll withholding, the workers can contribute to their 401 k accounts similarly their employers can match some or all of the contribution.
The investment earned in a traditional 401 K plan is not taxable till the time employee doesn’t withdraw that money.
Withdrawals can be tax-free in a Roth 401 K plan.
How does the 401 K Plans Work
Traditional and Roth are the two basic types of 401(k)s. It is at times also referred to as a “designated Roth account.”
Though both are similar in many respects but are different. A worker can have either one or both types of accounts.
Contributing to a 401(k) Plan
A 401 k plan is also known as a defined contribution plan. Here both the employee and employer can make contributions in the account, up to the dollar limitation set by the Internal Revenue Service (IRS).
The traditional pensions (not traditional 401(k)s) are referred to as defined benefit plans, here a specific amount of money needs to be provided by the employer to the employee upon retirement.
Over the past couple of years, there is an overflowing number of 401(k) plans compared to the traditional pensions, which are becoming rare, because now employers have shifted the responsibility and risk of saving for retirement to their employees.
Within their 401(k) accounts the employees are also responsible for choosing the specific investments, from the options provided by their employer.
The offerings from employers are an assortment of stock and bond mutual funds and target-date funds, which are a mixture of stocks and bonds appropriate in terms of risk for when that person expects to retire.
Sometimes the offerings include guaranteed investment contracts (GICs) provided by insurance companies and sometimes it is the employer’s own stock.
Contribution Limits
In a 401(k) plan, the maximum contribution by an employee or employer is adjusted periodically to account for inflation.
The basic annual limits on employee contributions in 2020 and 2021 are $19,500 for workers under age 50, and for those 50 and up it is $26,000 (This is inclusive of the $6,500 catch-up contribution).
If the employer also contributes or if the employee wants to make an added contribution then the total employee/employer contribution for workers under 50 for 2021 is limited to $58,000, or 100% of employee compensation, whichever is lower. and for those 50 and above the limit is $64,500.
Taking Withdrawals from a 401(k)
One should remember that their money in a 401(k) plan cannot be withdrawn without attracting a penalty.
If it is a traditional 401(k) then 401(k) account earnings are tax-deferred and in the case of Roths, it is tax-free.
When withdrawals are made by the owner of a traditional 401(k) that money (which was not taxed earlier) will be taxed as ordinary income.
Roth account owners (since they have paid income tax on the money they contributed to the plan) will not incur tax while withdrawing.
There are certain criteria that are spelled out by the IRS, like being totally and permanently disabled and the traditional and Roth 401(k) owners must be at least age 59½ when they start to make withdrawals.
Or, they will be charged an additional 10% early-distribution penalty tax on top of any other tax they owe.
The difference between traditional 401(k) vs. Roth 401(k)
Companies and their employees had just the choice of the traditional 401(k) when the 401(k) plans first became available in 1978. Roth 401(k) was introduced in 2006.
The former U.S. Senator William Roth of Delaware, who was the primary sponsor of the 1997 legislation that made the Roth IRA possible so Roth was named after him.
Some employees might opt for a traditional 401(k) and take advantage of the immediate tax break because they expect to be in a lower marginal tax bracket after they retire.
Whereas, some employees who expect to be in a higher bracket, can choose Roth so that they can avoid taxes later.
For a younger worker currently with a low salary but likely to rise substantially over time, a Roth could be the ideal choice.
Also since there is no tax on withdrawals, so all the money earned over years of being in the account is also not taxed.
Conclusion
A company-sponsored retirement account where employees can contribute is called a 401(k) plan, here the employers too may make equal contributions. Traditional and Roth are the two basic types of 401(k)s.
The employee contributions reduce their income taxes for the year they are made and when it is withdrawn they are taxed in a traditional 401(k).
But in Roth, employees make contributions with post-tax income but can make withdrawals tax-free.
Under the CARES Act, in 2020, there was relaxation in withdrawal rules and amounts for those affected by COVID-19, and RMDs were also suspended.
Do not put all of your savings into your 401(k) because you cannot easily access it or withdraw without penalty.
