401(k) Plan

A retirement and savings plan that allows employees to save a portion of their salary before taxes

What is a 401(k) Plan?

The 401(k) plan is a retirement and savings plan that enables employees to save a portion of their salary or paycheck before paying taxes by contributing to a retirement fund that can be accessed if certain conditions are met.

401(k) Plan

Employers typically offer such plans to their employees. 401(k) plans were designed to provide taxpayers a break on taxes on deferred income, and as a supplement to pension plans that were offered to employees.

A 401(k) plan is a type of defined-contribution plan, in the sense that the monetary component of retirement benefits are directly proportional to the contributions of the employees into their accounts.

It is different from regular pension plans, which are defined-benefit plans, where the employer plans and calculates the amount of retirement benefits for any employee based on several factors, such as salary and duration of employment.

Types of 401(k) Plans

There are currently two types of 401(k) plans offered by employers:

  • Traditional 401(k), which was first developed in 1978.
  • Roth 401(k), which was created in 2006.

The primary differences between the two types of plans lie in how contributions are taxed and the terms for withdrawals.

The benefits and drawbacks of each type of plan depend on the financial status and future of the individual:

  • For employees in lower marginal tax brackets (who anticipate higher earnings in the future), the Roth 401(k) may be more beneficial, since they save by paying lower taxes now as opposed to paying a large amount in income taxes upon withdrawal.
  • For employees in higher marginal tax brackets, the traditional 401(k) may provide better value, as it allows individuals to save substantial amounts by reducing their total taxable income.
  • However, it is important to note that the amount of contribution is capped at $19,500 annually, which means that highly compensated individuals can only save a certain amount by deferring income taxes in the future.

Features of a 401(k) Plan

1. Contribution limits

As per the latest IRS guidelines for the financial year 2020-21, people under the age of 50 can transfer at most $19,500 in their accounts annually. For those aged 50 and above, the maximum limit for the same is at $26,000.

In the case when employers match their employees’ contributions, the combined contribution for people under 50 is $57,000. The limit for people over 50 is $63,500, or the full amount of employee compensation, whichever is lower.

2. Treatment of taxes

In the case of a traditional 401(k), the amount deposited into the plan reduces the taxable income of the employee, but any amount withdrawn is taxed. On the other hand, taxes are deducted from deposits made into a Roth 401(k) scheme, whereas withdrawals are tax-free.

3. Withdrawals

Owners of all 401(k) accounts can start making withdrawals only after they are 59 years and 6 months old, or if they meet any other criteria as specified by the IRS rules, such as suffering from a permanent disability. Such emergency withdrawals before maturity to pay for an “immediate and heavy financial need” in IRS parlance are allowed without any penalty.

The needs include, but are not restricted to, purchase of a primary residence, medical expenses not covered by insurance, funeral expenses. Withdrawals made before retirement for any other purpose will face a penalty tax of 10%.

4. Required Minimum Distribution (RMD)

Withdrawals from a 401(k) scheme are sometimes referred to as distributions. Retired owners aged 72 and above must withdraw a certain proportion of the money in their accounts, as calculated on the basis of IRS tables. However, if the owners are still working at that age, then there is no compulsion for them to withdraw.

401(k) Plans – Advantages

  • 401(k) plans allow employees to save money on taxes by allowing them to make pre-tax contributions [Traditional 401(k)] or to save on income taxes upon withdrawal [Roth 401(k)].
  • For employers, 401(k) plans may reduce the cost associated with designing and implementing pension plans for employees by offering them a tax-advantaged retirement plan.
  • 401(k) plans are also an effective way of reducing the total taxable income for individuals, allowing them to ultimately save more.

Restrictions and Caveats

  • There are fees associated with investment management, consulting, and administration costs that must be paid upon enrollment into a 401(k) plan. In 2011, the average amount paid in management and administrative fees per employee was $250 in the United States.
  • It is important to note that the contributions to a 401(k) plan, be it Traditional or Roth, are capped at $19,500 for 2020. This limit is updated each year.

A crucial restriction that is typically placed by companies as insurance against employee turnover is time worked. Vesting refers to giving employees the right to secure an asset. In the context of 401(k) plans, vesting refers to providing employees with access to funds in their respective retirement accounts. Most employers require employees to work a certain number of hours before they’re vested.

Related Readings

CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification program, designed to transform anyone into a world-class financial analyst. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:

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