Investment Glossary – 401(k) Plan
As a child, the term “401(k)” was confusing to me. I thought it referred to the amount you had to save in order to retire. I saw commercials for retirement accounts and always wondered how all of these smart people determined that $401,000 was the right amount of money to retire on. Should you open more than one 401(k) if you needed more money than that? What if you didn’t get all the way to $401,000? Once I finally started to work in the financial industry, it quickly became apparent that a 401(k) plan doesn’t actually refer to the amount of money in the plan. Rather, a 401(k) plan is named as such for the most boring reason possible.
401(k) is the section of the Internal Revenue Code that established group-based retirement plans.
A 401(k) plan is a qualified plan sponsored by an employer that allows employees to make contributions, while simultaneously allowing employers to make matching contributions if they desire to as well. These contributions generally occur on a pre-tax basis, meaning that employees get a tax deduction in the year they make the contribution, but sometimes are post-tax because of situations specific to an employee. Regardless of whether the contribution is pre-tax or post-tax, all earnings in a 401(k) account occur on a tax-deferred basis, meaning there is no tax paid on any of the earnings until the money is withdrawn from the account.
401(k) plans are subject to annual employee contribution limits, with that limit rising to $19,000 in 2019. For employees age 50 and over, catch-up contributions are allowed, with the limit expanded by $6,000, meaning they can contribute a total of $25,000 per year. In recent years, Roth 401(k)s have grown in popularity, with many employers offering Roth accounts alongside conventional 401(k) options. Much like a Roth IRA, the Roth 401(k) allows contributions to go in after-tax, but the money grows tax-free forever, with no taxes ever due on any gains accrued in the account over its lifetime. 401(k) plans are portable once you leave an employer, but you are typically required to keep a plan with an active employer until you are over age 59.5.
What happens if you want to withdraw money before age 59.5?
Like most qualified accounts, 401(k) plans do have penalties for early withdrawals. If you are under the age of 59.5, you will be subject to a 10 percent penalty on any withdrawals in addition to the regular taxes required on a withdrawal. This makes 401(k) plans potentially ideal for long-term saving because of their tax-deferred (or tax-free in the case of a Roth 401(k)) nature, but if you think you need to access the money prior to age 59.5, they are probably not an ideal vehicle for you. This is something that needs to be considered when building an investment plan since you have to factor in the amount of risk you are taking in your investments and when you need access to your funds.
The investment options within 401(k) plans will vary based on the specific plan, but many plans have between 10 and 20 different options with various levels of risk available. While most 401(k) plans utilize mutual funds as their primary investment choice, there are other options available at some employers, such as exchange-traded funds and annuities. You are not required to contribute to a 401(k) plan, but when it comes to saving for retirement, it could be a strong choice for many people because of the high contribution limits and ease of use for the employee.
So a 401(k) plan actually has nothing to do with the amount of money you save in the plan, but rather just specifies how employers can set up retirement plans for their employees to contribute to over their careers. There are a ton of variations as far as specific investments, employer matching contributions, and expenses that vary from plan to plan, but the premise is simple – save for retirement in a tax-deferred or tax-free fashion on a regular basis.