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What is 401K

Table of Content

Last updated on April 1st, 2020
Written by: Rick Pendykosk

What is a 401(k) Plan?

A 401(k) is a retirement savings account that was created by Congress in 1981. It gets its name from the section 401(k) of the Internal Revenue Code.

The 401(k) employer-sponsored savings plan are established by businesses or self-employed persons to help their employees and business owners to save for retirement and also take advantage of the tax benefits offered to both the employees and the business owners.

The 401(k) plan allows an employee to contribute a portion of his/her salary into long-term investments. The employer may match the employee’s contribution up to a certain limit set by the IRS. However, this retirement account is funded through pre-tax payroll deductions.

These plans offer a convenient way to save for retirement because the contributions are automatically withdrawn from the paycheck and invested in funds of your choosing.

401(k) Contribution Limits

Whether traditional or Roth, an employee can defer a maximum of $19,500 for 2020 ($19,000 for 2019) from his/her salary to a 401(k) plan. For employees aged 50 years and above, an additional catch-up contribution of $6,500 ($6,000 for 2019) is allowed.

An employer and employee can make a maximum joint contribution of $57,000 for 2020 ($56,000 for 2019), or $63,500 for those 50 years and above ($62,000 for 2019).

401(K) contribution limits explained

Types of 401(k) Plans

There are various types of 401(k) plans, each with its own set of unique advantages and disadvantages. Some of these plans are:

  • Traditional 401(k)
  • Roth 401(k)
  • SIMPLE 401(k)
  • Solo 401(k) or Self Employed 401(k)
  • Safe Harbor 401(k)
  • 403(b) – non-profit organizations or government agency
  • Profit-Sharing Plans

401(k) Investment Options

The 401(k) investment options available to you will depend on what choices your plan sponsor makes and who your plan provider is. Nevertheless, knowing the different types of investment options will help you create an investment portfolio that’s better suited for your long-term financial needs.

Each type of 401(k) plan allows you to decide how to invest the contributions you make. Some plans even allow you to decide how to invest your employer’s matching contributions. But there are some plans that allow the employer to make that choice. And that also includes the right to provide the match in company stock.

Most 401(k) plans offer a minimum of three investment options, while some plans provide more than a dozen of choices. However, the average plan provides 8 to 12 investment alternatives. The mutual fund is the most common type of investment choice offered by a 401(k) plan. But sometimes a combination of mutual funds, stable value funds, guaranteed investment contracts (GICs) or company stock, and variable annuities is also offered. Some plans also provide brokerage accounts that allows you to invest in stocks, bonds, mutual funds and other types of assets.

401(K) Benefits

The benefits of investing in a 401(k) plan are: 

  • Employers may offer to match a portion of what you contribute
  • Higher contribution amounts than allowed in SIMPLE IRA or SEP plans
  • Disciplined savings through automatic payroll deductions
  • Tax-deferred growth on investments while in the 401(k) plan
  • Access to a wide range of investment options
  • Control over when taxes are paid on retirement assets (pre-tax versus post-tax Roth contributions)
  • Reduced taxable income through pre-tax salary contributions
  • Option to take a loan from retirement savings
  • Tax credits for some employees
  • Ability to transfer assets to other retirement accounts when retiring or changing jobs

How to Open/Setup a 401(k) Plan

  • Employer
    As an employer or a self-employed individual, you can set up a 401(k) plan in the following steps:

    • If you’re self-employed, figure out what type of plan you want – Solo (k), SEP, or SIMPLE.
    • Decide if you want to use the services of a financial advisor or other consultants.
    • Determine what provisions you want in your plan. Matching, safe harbor, loans, Roth 401(k)?
    • Choose a vendor after evaluating investment costs and fees, flat-rate pricing, technology, and other features.
    • Submit the completed adoption agreement and other agreements to your vendor(s).
    • Communicate and educate your employees (if any) of the 401(k) plan and its features and benefits.
    • Set up individual 401(k) participant accounts.
    • Fund the plan through payroll deductions or employer contributions.
    • Review the plan regularly to figure out if it’s meeting the needs of the participants.
    • Monitor and make changes in the plan as and when the regulations change, and/or your need evolves.
    • Update the participants with the required information regularly.
  • Employee
    If your company offers a 401(k) plan, you may be eligible to participate in it. If you are 21 years and above and have been working with the current employer for at least a year, you become eligible for it right away. So check up with your human resources department regarding your eligibility. If you are eligible to participate in a 401(k) plan, these are the step you should take:

    • Fill out the 401(k) enrolment forms.
    • Designate a beneficiary. A beneficiary is someone who will inherit your 401(k) plan if something were to happen to you.
    • Assuming that your employer’s plan has both traditional and Roth options, decide which one you want to go for.
    • Figure out how much of your salary you want to contribute towards your retirement plan. Try to contribute enough money to capitalize on your full employer match.
    • Contributions to your account will be automatically deducted from your paycheck.
    • You can change the contribution rate as and when the need arises. For example, if you started out by contributing 5% of your salary, and somewhere in the middle of the year, your rent goes up, you can talk to your HR to reduce your contribution. And when your financial situation gets better, you can increase your 401(k) contributions up to the annual limits specified by IRS.

Rules for Withdrawing Money

  • 401(k) Hardship Withdrawal
    The IRS imposes a 10% penalty for early withdrawal from your 401(k) plan if you are younger than 59 1/2 years. However, you can make a hardship withdrawal to cover the following expenses if your employer permits it:

    • Medical expenses incurred by you, your spouse, or your dependents.
    • College tuition and other associated educational fees for you, your spouse, children and dependents
    • Costs associated with the purchase of your principal residence, not mortgage payments
    • Some expenses incurred for repairing the damage to your principal residence
    • Costs required to prevent being evicted from your home or foreclosure on your principal residence
    • Funeral expenses

    To qualify for 401(k) hardship withdrawal, you have to provide financial proof to your employer that indicates your need to take money out of your 401(k). If you don’t want to disclose your finances, you have an alternative to “self-certify.” Once you withdraw from your 401(k) on the basis of a hardship withdrawal, you won’t be able to make new 401(k) contributions for the next six months.

    Check with your HR department to see if they allow hardship withdrawals and whether you qualify.

  • Penalty-Free 401(k)/Non-Financial Hardship 401(k) Withdrawal
    A penalty-free withdrawal allows you to withdraw money before age 591/2 without paying a 10% penalty, but your withdrawal is taxable. To qualify for penalty-free withdrawal, you need to meet any of these situations:

    • You need to have a disability that qualifies you for this type of a withdrawal
    • Your medical expenses are up to the amount that is allowed as a medical expense deduction
    • You are ordered by the court to give money to your divorced spouse, your child or dependent
    • You’ve experienced a disaster for which the IRS has granted relief
    • You’ve left the company and have set up a schedule to make equal periodic payments for at least 5 years or until you turn 591/2 years, whichever is longer

    Contact your HR department to check whether your employer allows such kind of withdrawals and if yes, how you should proceed.

  • 401(k) Required Minimum Distributions (Post-Retirement Rules)
    In April the year after you turn age 72, you have to start taking 401(k) withdrawals, regardless of whether you want it or not. If you miss taking these required minimum distributions, or if you withdraw the wrong amount, the IRS will penalize you.These RMDs are calculated based on your life expectancy. Your plan administrator must determine your RMD. So, check the IRS’ RMD rules to determine your required minimum distribution.
  • 401(k) Distributions in Retirement
    Once you turn 59 1/2, you can start making withdrawals. You can typically take a periodic distribution or a lump sum distribution. The key here is to manage your distributions so that you don’t outlive your money.Although a lump sum gives you access to a larger amount of money, it is taxable, and you have to pay the tax right away. Moreover, it takes away a major chunk from your nest-egg, all at once.If you do not wish to withdraw a lump sum, and if your company allows, you can choose to receive a certain amount of money every month or every quarter. If you want to change the amount, you can do so once in a year. However, there are some plans which allow you to make changes more frequently.

Loans From a 401(k) Plan

You can take a loan from your 401(k) plan, provided your employer approves it. If you are eligible for this option, you can borrow up to 50% of the vested balance up to a limit of $50,000. The loan usually has to be repaid within 5 years, but a longer repayment period is allowed for a primary home purchase.
The interest rate that you pay to yourself for borrowing the money from your 401(k) plan will be comparable to the interest rate charged by the banks and lending institutions for a similar type of loan.
If you fail to repay the borrowed amount, the unpaid balance will be considered as a distribution, and it will be penalized or taxed accordingly.

401(k) Rollover

If you leave your job or are laid off, you can rollover your 401(k) plan to another qualified retirement account, such as an IRA or a new self-directed 401(k). This rollover doesn’t attract penalties or taxes. However, if you’ve been taking distributions from your 401(k), the rollover shouldn’t take more than 60 days. If you exceed the time period, the rollover becomes a taxable distribution.

401(k) Options When Changing Employers

When changing employers, the employee has four options:

  1. Let the Assets Remain in the Old Employer’s 401(k) Retirement Plan
    Regardless of whether you are still with the employer or changed jobs, many 401(k) plan administrators charge fees to manage your account. If you have multiple accounts with multiple employers, these fees can take a substantial amount from your retirement net worth.
  2. Rollover your 401(k) to the New Employer’s 401(k) Plan
    You are eligible for this option only if you have another job offer before you leave your current employer. In most cases, a rollover to an IRA may be the best option. So, how to decide? Check out the investment options you have with your new employer’s 401(k) plan. If you are not happy with the choices, then a 401(k) rollover to an IRA is a good option.
  3. Rollover your 401(k) to Move the Assets to an IRA
    Completing a 401(k) rollover may be the best choice because it allows your money to continue compounding tax-deferred and provides you maximum control over your asset allocation, as you are not restricted to the investments offered by 401(k) plan provider.This is how it works:
    A distribution of the current 401(k) plan assets is ordered. This order is reported on the IRS Form 1099-R. Once the assets are received, the employees must contribute to the new retirement plan within 60 days. This is reported on IRS Form 5498. The government allows 401(k) rollovers strictly once every 12 months.
  4. Cash-Out the Proceeds
    Cashing out a 401(k) when leaving or changing jobs is an option, but it is most often a poor decision. The decision can cost you far more than penalty fees and taxes. You would lose a decade tax-deferred compounding capital that you could have earned if you chose to do a 401(k) rollover.