3/13/2023
A 401(k) retirement plan is a retirement savings plan offered by many U.S. employers that also reduces your IRS tax bill. Thus the 401(k) is an employer-sponsored retirement account into which the worker can also contribute extra income, and employers can match contributions.
Not all U.S. companies offer 401K plans to their employees, but most do. The idea is to help the worker or employee save for retirement. It is very important to save for retirement so that you have a reasonable income at the end of the working age.
The employee gets a double benefit, a tax break and retirement savings, which is why 401(k) plans are so popular in the United States.
Main features of a 401(k) retirement plan
What characterizes 401k plans over other forms of retirement savings is:
- The 401k plan is a plan sponsored by the employing company, if the company does not offer this type of plan to its workers the worker will not be able to use it. Most U.S. companies offer 401k plans to their employees.
- Both employers and employees can make contributions, normally the employer contributes at most the same amount as the employee, but in exceptional cases this amount can be higher.
- There are two types of plans, the 401k and the Roth 401, which differ in the way they are taxed.
- The traditional 401k plan allows employees to reduce taxes on contributions up to the maximum amount set each year by the IRS.
- In 401(k) plans, taxes are paid at retirement, which is not the case with Roth plans.
- Employees are responsible for choosing the specific investments to be made from their 401(k) account.
You may be interested in: IRS customer service phone number
Traditional 401(k) Vs Roth 401(k) Plan
In 2006, new plans called Roth 401k plans emerged as an alternative to the popular 401k plans. Although both plans are retirement funds, the worker must choose one or the other, and the main difference is in the way of taxation.
401k plans have an immediate tax exemption, while Roth plans pay taxes on their contributions, but avoid paying taxes in the future on those contributions and the profits generated by their investment.
Traditional 401(k)
With a traditional 401(k), employee contributions are deducted from gross income, which means the money comes from the employee's payroll before income taxes are deducted.
As a result, the employee's taxable income is reduced by the full amount of the contributions for the year and can be claimed as a tax deduction for that tax year. No taxes are due on the money contributed or earnings until the employee withdraws the money, usually in retirement.
Roth 401(k)
With a Roth 401(k), contributions are deducted from the employee's after-tax income, which means that the contributions come from the employee's salary after income taxes have been deducted.
As a result, there is no tax deduction in the year of the contribution. When the money is withdrawn during retirement, no additional taxes are due on the employee's contribution or investment earnings.
Employees who are in a lower tax bracket may want to opt for a traditional 401(k) plan to take advantage of the immediate tax break, and employees who expect to reach a higher salary may prefer to opt for a Roth 401, as they can avoid paying higher taxes in the future.
When it comes to choosing one plan or the other, it is difficult to advise the best one because we do not know the tax burden in the future or the employee's salary in a few years. In some cases it is possible to opt for both plans and divide the money between them.
Contribution limits to the 401(k) plan
The maximum amount an employee or employer can contribute to a 401(k) plan is adjusted periodically to account for inflation, which measures price increases in an economy.
If the employer also contributes, or if the employee elects to make additional non-deductible after-tax contributions to his or her traditional 401(k) account, there is a total employee and employer contribution amount for the year.
401(k) withdrawals
Money contributed to 401(k) plans is very difficult to recover; the money in these plans is for retirement. For emergencies and unforeseen events, it is advisable to have a savings account, since we will generally not be able to use the money saved in a 401k plan.
Earnings in a 401(k) account are tax-deferred in the case of traditional 401(k)s, and tax-free in the case of Roths. When the owner of a traditional 401(k) makes withdrawals, that money will be taxed as ordinary income.
Roth account holders have already paid income taxes on the money they contributed to the plan and will not owe taxes on their withdrawals as long as they meet certain requirements.
Both traditional and Roth 401(k) owners must be at least 59½ years old, or meet other criteria set by the IRS, such as being totally and permanently disabled, when they begin taking withdrawals, otherwise they will generally face an additional tax or early distribution penalty of 10% on top of any taxes they owe.
Some employers allow employees to borrow against their contributions to a 401(k) plan. If you take out a 401(k) loan, be aware that if you leave your job before the loan is repaid, you will have to pay it back in a lump sum or face the 10% early withdrawal penalty.
What happens to my 401(k) retirement plan if I leave my job?
When a worker leaves her job with a company and has a 401k plan she has 4 different options.
Withdraw the money
This is the least recommended option and should only be done if the employee has great financial urgency. The money will be taxable in the year it is withdrawn.
The employee will be hit with the additional 10% early distribution tax unless he or she is over age 59 1/2, permanently disabled, or meets the other IRS criteria for an exception to the rule. You will pay all of the unpaid tax and a 10% penalty, so this is not recommended.
In the case of Roth plans you can withdraw the money tax-free as long as the plan is at least 5 years old.
Rollover 401(k) to an IRA account
The money can be moved to an IRA account at a brokerage firm, mutual fund, or bank. Using this system, the employee can avoid immediate taxes and maintain the tax-advantaged status of the account. In addition, the employee will be able to choose from a wider range of investment options than with his or her employer's plan.
In order to enjoy the tax- and penalty-free advantage of withdrawing your 401(k) funds, you must roll them over to another retirement account within 60 days of withdrawal. Otherwise, you'll face paying taxes.
Leaving 401(k) with former employer
In many cases, employers will allow a departing employee to keep a 401(k) account in his or her former plan indefinitely, even though the employee can no longer make contributions to it.
This generally applies to accounts with a minimum value of $5,000. In the case of smaller accounts, the employer may give the employee no choice but to move the money elsewhere.
Leaving the 401(k) money where it is may make sense if the former employer's plan is well managed and the employee is satisfied with the investment options it offers.
Moving the 401(k) to a new employer
We can usually roll over our 401(k) balance to our new employer's plan. As with an IRA rollover, this maintains the tax-deferred status of the account and avoids immediate taxes.
It can be a smart decision if the employee is not comfortable making the investment decisions involved in managing a rollover IRA and prefers to leave some of that work to the administrator of the new plan at the new company.
Español: ¿Qué es el plan de retiro 401(k) en Estados Unidos?