Americans had $7.7 trillion in a 401(k) plan at the end of 2021, making the 401(k) retirement plan one of the most popular retirement investment vehicles in the United States.
What are 401k plans and why are they widely used? Here is a closer look.
Tax Benefit Retirement Plan
A 401k plan is a tax-advantaged retirement plan that many US companies offer to their employees. The term 401(k) refers to a section of the US tax code that covers retirement plans.
The company creates a 401(k) plan for its employees, who subscribe to the plan and agree to withhold and deposit a portion of their regular paycheck into a 401(k) plan account.
With 401(k) plans, employees can choose from several investment vehicles to fund their retirement, including:
- index funds
- Target date boxes
- investment funds
- In addition to stocks, bonds and individual money market funds.
Plan holders are restricted to a maximum 401(k) plan contribution each year, up to $20,500 for 2022, according to the IRS. Employees can invest up to the maximum amount, as well as receive matching contribution assistance from employers.
For example, an employee who earns $50,000 annually might contribute 10% of that salary to a 401(k) plan on an annual basis, or $5,000.
Additionally, that employee can receive a 100% matching contribution from the employer of up to 5% of the worker’s annual earnings, or $2,500. In total, the employee contributes $7,500 to a 401(k) plan for the year, which can be invested for retirement on a tax-deferred basis.
The IRS also allows an additional 401(k) “compensation” contribution of $6,500 annually for Americans age 50 and older.
Read: How does Rich retire? Start saving and investing now
Traditional 401(k) and Roth 401(k)
An employee may be able to choose between a traditional 401k plan or a Roth 401k plan.
The traditional 401k plan: The most widely used 401(k), the traditional 401(k) plan allows employees to contribute to the plan before any taxes are withheld, reducing the employee’s taxable income.
Roth 401(k) plan: On a tax basis, Roth 401(k) plans are treated differently than traditional 401(k) plans. Instead of deducting taxes from an employee’s gross income, Roth Fund contributions are made after income taxes are deducted from the employee’s paycheck.
Read: Can I contribute to my Roth 401(k) regardless of my income?
The two plans differ on the back end as well. Unlike a traditional 401(k) plan, where the employee pays taxes on plan withdrawals in retirement, a Roth 401(k) allows plan owners to avoid paying taxes on plan withdrawals in retirement.
While employees typically choose between a traditional 401(k) and a Roth 401(k), the IRS allows 401(k) investors to choose a combination of both plans in a company-sponsored retirement portfolio—but only up to specific annual tax-deferred limits. 401(k) plan contributions.
Read: Comparing Roth IRAs and Roth 401(k)s
Generally, holders of 401(k) plans can begin making withdrawals from a 401(k) account when they reach age 59 and a half, or they can begin withdrawing funds early if they are hindered and meet the IRS 401(k) plan early withdrawal criteria.
If a 401(k) plan holder takes the money early in the form of a loan and doesn’t pay off the loan in full and within a set schedule, that plan holder typically must pay a 10% early withdrawal penalty in addition to other taxes they owe to the IRS.
Minimum Distribution Required
While retirement savings can defer taxes on retirement savings, it cannot be deferred forever. People with tax-deferred accounts, such as traditional 401(k)s or IRAs, are required to take distributions from these accounts each year after a certain age is reached.
Retired savers born after June 30, 1949 must begin receiving the required minimum distributions by April 1 of the year they turn 72.
Those born before July 1, 1949 were required to start taking RMD by April 1 of this year, and would have to receive another distribution by December 31, 2022 and by December 31 each year thereafter.
The penalties for not taking the minimum required distributions are very severe. Check out this RMD calculator from AARP.
More: Managing RMDs in a Bear Market
What 401(k) plans offer
A 401(k) plan offers Americans a tax-advantaged, company-sponsored retirement plan during their working years.
With regular investments and matching contributions from employers, 401(k) owners can get the best of both worlds — long-term tax-deferred investment opportunities and tidy nest eggs.