Traditional 401(k) plans are the most common offered private employer sponsored retirement plans.
Key aspects of Traditional 401(k) plans:
- They are a pre-tax investment account, meaning that the money you place in this account is deducted from your check before taxes are collected. For example, if your weekly check is $1,000 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.
- 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.
- Any company, private or public, can have 401(k) funds if there are 20 or more employees.
- Employers must allow all employees to participate if they are 21 and above, have one year of service, and have 1000 hours of service per year. There are some restrictions beyond this for people who are not US citizens and some types of union members.
- 401(k) plans usually provide at least three investment choices, but some plans offer much more options. But, again, this will vary from company to company. This variation in options is good to ask about in the hiring process.
- For 2021, yearly contribution limits are $19,500 for people younger than 50 and an extra $6,500 catch-up amount for 50 and older. Contributions are made from January to December of that year.
- The average match for most companies in 2019 was 5.3%. The amount and ways matching is created in a 401k plan widely varies, but the total contribution between employer and employee cannot exceed $58,000. In addition, matching cannot make up more than 25% of compensation for an employee.
- Vesting refers to the period you need to stay with an employer to keep any money that they match. The vesting period varies with employers but usually is in the range of 3 to 6 years. There are also variations on vesting schedules. Cliff vesting is where you go 100% vested at a set period. Graded vesting is where you earned a percentage towards 100% each year. An example would be you are 33% vested year one, 66% year two, and 100% at year three.
- 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.
- If you leave an employer, you can take your money with you.
- 401(k)s are required to perform nondiscrimination tests (NDTs) annually to ensure that 401(k) retirement plans benefit all the employees, not just high earners or company owners.
- Fees vary 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.
- The earliest you can make 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.
- Required Minimum Distributions (RMDs) need to start at 72, but you can still contribute to this type of plan if you are still employed. With some plans, that contribution offsets the RMDs.
- 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.
- For 2021, the IRS has income limits for 401(k) contributions for people earning more than $290,000, which means that the company match is based on $290,000. Here is how it works, your company matches 4%, but if you contribute $19,500 and you make $400,000, they will only match 4% of $290,000 or $11,600.
Advisory services offered through Capital Asset Advisory Services, LLC, a Registered Investment Advisor. This material has been prepared for informational purposes.