Traditional 401(k) plans are the most commonly offered private employer sponsored retirement plans.
Key aspects of Traditional 401(k) plans:
- They are a pre-tax investment account, meaning the money you place in this account is deducted from your check before taxes are collected. For example, if your weekly check is $1000 and you contribute $50 to your 401(k) account, it will show you made $950 weekly on your annual tax return. That money accumulates in the account tax-free until you withdraw it.[1]
- With all investment accounts, you expose some or all your invested money to loss for the chance to earn a higher profit. Investment gains hinge on an ongoing and long-term investment strategy that uses your risk tolerance and diversification to mitigate some risks. Even with these in place, you are exposing your money to loss.[2]
- Any private or public company can have 401(k) funds if there are 20 or more employees.1
- Employers must allow all employees to participate if they are 21 and above, have one year of service, and have 1000 hours per year. There are some restrictions beyond this for people who are not US citizens and some types of union members.1
- 401(k) plans usually provide at least three investment choices, but some offer many more options. But, again, this will vary from company to company. This variation in options is good to ask about in the hiring process.[3]
- The average match for most companies in 2023 was 5%.[9] The amount and ways matching is created in a 401k plan widely varies, but the total contribution between employer and employee cannot exceed $69,000. In addition, matching cannot make up more than 25% of compensation for an employee. [10],[11]
- Vesting is when you must stay with an employer to keep any money they match. The vesting period varies with employers but usually is in the range of 3 to 6 years. There are also variations in vesting schedules. Cliff vesting is where you go 100% vested at a set period. Graded vesting is where you earn a percentage of 100% each year. An example would be you are 33% vested in year one, 66% in year two, and 100% in year three.[12]
- A 401(k)-plan sponsor is the plan fiduciary, legally responsible for selecting the plan’s investment options and monitoring their suitability. Generally, your employer is your 401(k)-plan sponsor.[13]
- If you leave an employer, you can take your money with you.[14]
- 401(k)s are required to perform nondiscrimination tests (NDTs) annually to ensure that 401(k) retirement plans benefit all employees, not just high earners or company owners.[15]
- Fees vary from plan to plan, but the three categories are investment fees, plan administration fees, and individual service fees. It is crucial to understand how much you are paying in fees.[16]
- The earliest you can take penalty-free withdrawals is 59 ½, and the penalty is an extra 10% on top of the taxes collected. However, there are some exemptions to the early withdrawal penalty- if you are permanently and totally disabled, if you lose your job at 55 or older, if you have medical expenses that exceed 10% of your modified adjusted gross income, with some divorce settlement types and if you die.8
- You can take a low-interest loan on 401(k) accounts, up to $50,000 or 50% of your account balance. Still, you will have to pay it back sometimes within 90 days but definitely within five years (this period may be extended if the money is used to buy a primary home) or at leaving that job, or it becomes taxable income. The payments will most likely be held back from your paycheck. Some plans don’t let you contribute to your account until the loan is paid back. Interest charges go directly back into your retirement account.[19]
If you want to explore investment accounts that would work for your personal or retirement goals, Scarlet Oak Financial Services can be reached at 800.871.1219, or you can contact us here. To sign up for our weekly newsletter with the latest economic news, click here.
Source:
[1] https://www.investor.gov/additional-resources/retirement-toolkit/employer-sponsored-plans/traditional-and-roth-401k-plans
[2] https://www.investor.gov/sites/investorgov/files/2019-02/Saving-and-Investing.pdf
[3] https://www.finra.org/investors/learn-to-invest/types-investments/retirement/401k-investing/investing-your-401k
[4] https://www.kiplinger.com/retirement/retirement-planning/602191/401k-contribution-limits-for-2021
[5] https://www.bankrate.com/retirement/401k-contributions/
[6] https://www.irs.gov/newsroom/irs-announces-changes-to-retirement-plans-for-2022
[7] https://www.irs.gov/newsroom/401k-limit-increases-to-23000-for-2024-ira-limit-rises-to-7000#:~:text=Highlights%20of%20changes%20for%202024,to%20%247%2C000%2C%20up%20from%20%246%2C500.
[8] https://www.irs.gov/newsroom/401k-limit-increases-to-23000-for-2024-ira-limit-rises-to-7000
[9] https://www.investopedia.com/articles/personal-finance/120315/what-good-401k-match.asp
[10] https://www.investopedia.com/articles/personal-finance/112315/how-401k-matching-works.asp
[11] https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits
[12] https://www.gobankingrates.com/retirement/401k/is-money-401k-really-vesting-works/
[13] https://www.investopedia.com/terms/e/erisa.asp
[14] https://www.thebalance.com/how-to-withdraw-money-from-a-401-k-or-ira-2894212
[15] https://www.forusall.com/401k-blog/401k-nondiscrimination-testing/
[16] https://smartasset.com/retirement/what-are-401k-fees
https://www.investopedia.com/terms/1/401kplan.asp
[17] https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmd
[18] https://www.tiaa.org/public/support/faqs/required-minimum-distributions
[19] https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-loans
[20] https://www.fool.com/retirement/plans/401k/income-limits/
[21] https://www.irs.gov/pub/irs-drop/n-22-55.pdf
[22] https://www.irs.gov/pub/irs-drop/n-23-75.pdf
https://www.investopedia.com/ask/answers/roll-into-403b.asp
https://www.merrilledge.com/ask/retirement/rollover-a-403b-to-ira-retirement-account
https://www.investopedia.com/ask/answers/100314/what-difference-between-401k-plan-and-403b-plan.asp
This material has been prepared for informational purposes. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on individual circumstances.