Saving for Retirement - The Traditional 401(k) Plan
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What is a Traditional 401(k) Plan?
Named after its section in the U.S. Internal Revenue Code, a Traditional 401(k) is a retirement savings plan offered to employees by many employers in the United States. By signing up for a 401(k), an employee agrees to have a percentage of each paycheck paid directly into an investment account and the employer often (but not always) matches part or all of that contribution. With a traditional 401(k), employee contributions are made with "pre-tax" dollars, meaning they come from the employee's gross income before taxes are deducted. Because of this pre-tax structure, 401(k) contributions will reduce your current tax burden and help you save for retirement. However, it also means that withdrawals will be taxed, even after retirement age.
How does employer matching work?
Employers will often (but not always) offer a 401(k) “match” to their employees. While these matches vary from employer to employer, they very typically work in percentages.
Here is a basic example: an employer chooses to match up to 3% of an employee’s salary. In this scenario, if an employee with a salary of $100,000 contributes $3,000 (3% of salary) to his/her 401(k), the employer will match that 3% and the total employer-employee contribution will be $6,000. Suppose the same $100,000 employee contributes $6,000; the employer will only match up to 3%, so the total employer-employee contribution would be $9,000 ($6,000 from the employee plus $3,000 from the employer).
Here’s a slightly more complex example: an employer chooses to match every dollar contributed up to 3% of the employee’s salary and 50 cents of every dollar contributed after that up to 6% of the employee’s salary. In this scenario, if an employee with a salary of $100,000 contributes 6% of his/her salary ($6,000), the employer will end up matching the first 3% entirely (dollar for dollar; $3,000) but only half of the next 3% (50 cents for every dollar; $1,500). In this scenario, the total employer-employee contribution would amount to $10,500.
Investment options in Traditional 401(k) Plans
Employees are typically allowed to choose from a list of several different investment portfolios offered by their employer. These portfolios typically include a variety of stock and bond mutual funds and target-date funds designed to reduce the risk of investment losses as the employee approaches retirement. When an employee is young, a portfolio with large allocations to relatively “riskier” assets may not be a bad idea (*not investment advice). However, as retirement age approaches, many attempt to reduce their exposure to “risky” assets. These plans may also include guaranteed investment contracts (GICs) issued by insurance companies and/or the stock in the employer’s own company. Although uncommon, some companies offer a self-directed 401(k), where the employees are free to choose their own investments.
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How much can you contribute to your Traditional 401(k)?
Contribution limits to a 401(k) plan are adjusted periodically to account for inflation. For 2021, the annual limit on employee contributions was $19,500 for workers under age 50. For 2022, the limit for employees under the age of 50 has been raised to $20,500 for the year. However, those aged 50 and over can make an additional $6,500 “catch-up” contribution in 2022.
If the employer also contributes, there is a limit on the total employee-and-employer contribution amount for the year. For workers under the age of 50 in 2022, the total employee-employer contributions cannot exceed $61,000 for the year. For those over the age of 60, Including the catch-up contribution of $6,500, the limit is $67,500.
Leaving a job after making Traditional 401(k) contributions
Suppose you’ve been contributing to a 401(k) and you leave your job or find a new employer. What happens to that money? According to Investopedia, you generally have the following four options:
Withdraw the money: You can choose to withdraw money from your 401(k) after leaving your job. However, this may be a bad idea, as the money will be taxable in the year it's withdrawn. Further, unless you’re over 59½, permanently disabled, or meet other IRS criteria, you will incur an additional 10% early distribution tax .
Roll your 401(k) into an IRA: You can move the money in your 401(k) account into an IRA at a brokerage firm, a mutual fund company, or a bank. In this case, you can avoid immediate taxes and maintain the account's tax-advantaged status. You’ll also have access to investment opportunities outside those offered by your previous employer. Note that the IRS has relatively strict rules on rollovers and how they need to be accomplished, so please consult with professionals when taking this route. Also note that funds withdrawn from your 401(k) must be rolled to another retirement account within 60 days to avoid taxes and penalties.
Leave your 401(k) with your former employer: Some employers will allow you to keep your 401(k) account in their former plan indefinitely, however you will no longer be able to make contributions to the account. If you feel that your former plan was well-managed, this option might make sense to you. However, if you’re an employee who changes jobs frequently, be sure not to forget about any of your 401(k) plans!
Move your 401(k) to your new employer: You may be able to move your 401(k) balance to your new employer's plan. As with an IRA rollover (see point 2, above), this maintains the account's tax-deferred status and avoids immediate taxes. If you’re not comfortable with making the investment decisions involved in managing a rollover IRA and would rather have your funds managed by your new employer, this option may be best for you.
Withdrawing money from your Traditional 401(k)
Once money goes into a 401(k), it is difficult to withdraw it without paying taxes. Whereas withdrawals from a Roth IRA (covered in last week’s newsletter, here) are tax-free, withdrawals from a Traditional 401(k) are taxed as ordinary income. Similar to Roth IRAs, Traditional 401(k) owners must be at least 59½ years old (or meet other criteria such as being totally and permanently disabled) to begin making withdrawals. “Underage” withdrawals typically incur a 10% early-distribution penalty tax.
Traditional 401(k) account holders are subject to required minimum distributions (withdrawals) after reaching the age of 72. After the age of 72, 401(k) owners who have retired must withdraw at least a specified percentage from their 401(k) plans. The percentage which must be withdrawn is determined using IRS tables based on life expectancy at the time.
It’s never too early to start saving for retirement
As we said in our introduction to this series, if you take one thing from this series on retirement investing, let it be this: it’s never too early to start saving for retirement - it may seem like a lifetime away, but time will go fast and your future self will be glad you started saving early! As always, we hope that you will find this series useful and please don’t hesitate to reach out with comments or questions about the content! Here is a running list of the articles included in this series:
Saving for Retirement - The Traditional 401(k) Plan
Saving for Retirement - Pensions (Coming next week!)
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Finish out the week strong!
Dan & Brandon
Disclosure: The article was written by Daniel Kuhman and Brandon Keys, and it expresses the author's own opinions. The information presented in this article is for informational purposes only and in no way should be construed as financial advice or recommendation to buy or sell any stock, asset, or cryptocurrency. Brandon and Daniel are not financial advisors. We encourage all readers to do further research and do your own due diligence before making any investments.