20 Oct Traditional and Roth 401K Plans
A 401K plan is sponsored by an employer as a retirement savings plan for an employee. It’s a defined-contribution plan, meaning that the balance in the employee’s acount depends on contributions made to the plan and the performance of plan investments. The employer is usually not required to make contributions to the plan but will often offer a match. Part of the employee’s paycheck is put into either a 401K pre-tax or a Roth 401K after taxes are taken out. These plans grow tax-free, and pre-tax contributions are taxed upon withdrawal. Roth 401K plans have tax-free withdrawals.
The 401K plan gained popularity in the 1980s as an alternative to a pension plan, which most employers used to provide. A pension fund is simply an employer-managed account that pays out a steady income over the course of retirement, but when pensions became too costly for employers, organizations started replacing them with 401K plans. (Government employees and members of strong unions may still be eligible for a pension plan.)
Roth 401K plans have been allowed since 2006, and many employers now offer them. One of the primary benefits of a Roth 401K is that there are no income restrictions to contribute, like there are with Roth IRAs.
Most 401K plans offer a variety of mutual funds composed of bonds, money market investments, and stocks. The participant in the plan controls how the funds are invested, but the most popular option is target-date funds, which start out as aggressively as desired but become more conservative as you approach retirement.
What does 401K stand for?
The 401K gets its name from the section of the tax code in which it is governed. Subsection 401(k) spells out the conditions for these plans, including restrictions and limitations. For example, in some cases, there is a vesting period during which the participant doesn’t have access to the employer contributions. This vesting period can vary, but it’s an effort to prevent employees from leaving a company too soon. You do have access to your own contributions immediately, however.
How much can you contribute to a 401K per year?
There are limits to the amount you can contribute to your 401K each year—and some factors you should consider. You should put in the maximum matching amount, if feasible, if your employer matches contributions. Many employers will offer a match. If that’s the case, it is a good idea to contribute at least the matching amount. That’s free money you’re leaving on the table if you’re not taking advantage of it.
There are limits to employee elective deferrals, which are the amounts contributed to a plan by the employee. Unless they’re for a Roth 401K, these elective deferrals are excluded from the employee’s gross income. The 2016 limit for traditional and safe harbor 401K plans is $18,000. However, if you’re over 50 at the end of the calendar year, you can add an additional $6,000 in catch-up contributions.
When can 401K savings be withdrawn?
Since your 401K is a retirement plan, it is meant to be withdrawn no earlier than age 59½. Most withdrawals taken before then will be hit with a 10% early withdrawal penalty by the IRS. However, many plans offer in-service rollovers at age 59½ or even earlier. This allows you to roll your 401K over to an IRA, potentially expanding your investment options significantly. You can also roll your 401K over upon termination from an employer.
There are a few reasons to withdraw early, but we don’t typically recommend early withdrawal unless it’s necessary. Be sure to speak with your financial advisor about your 401K and the best options for your particular situation.
Required Minimum Distributions
Since traditional 401K plans are tax-deferred, your contributions can grow unhindered until you begin withdrawing, but there’s a limit. Once you reach age 70½, you are required to withdraw from your 401K. In fact, the latest you can wait is April 1 of the year in which you turn 70½. Each year after that, you must receive the required minimum distribution (RMD) for the year by December 31. You will be penalized for taking an amount less than what is required by the IRS. The amount of your RMD is determined by the IRS.
The Roth 401K plan is a bit different, though. If a Roth 401K is rolled over to a Roth IRA, there are no required minimum distributions.
Is a 401K taxable?
The traditional 401K plan is tax-deferred, meaning that taxes are collected upon withdrawal, rather than when you contribute. Roth 401K plans, on the other hand, receive contributions that have already been taxed, and withdrawals are tax-free.
Talk to your financial advisor about the benefits and conditions associated with both traditional and Roth 401K plans.
As you can see, there’s a lot to consider related to your 401K, but this article is not a comprehensive guide to 401K plans or other retirement investment plans. You should consult your financial advisor before making any major financial decisions. Click here to learn how a CERTIFIED FINANCIAL PLANNER™ professional can help you plan for retirement.