How do 401(k) Plan Work?

There are two different types of 401(k) accounts: traditional and Roth. The main difference between the two is how they are taxed. An employee may have either type of accounts or both depending on what is offered by their employer.

Contributing to a 401(k) Plan

A 401(k) is known as a defined contribution plan. The employee and employer can make contributions up to the limits set by the Internal Revenue Service. For 2021, the contribution limit is $19,500 for individuals under 50 and $26,000 for the oldies that are above 50.

In the last few decades, 401(k) plans have become the main retirement account for individuals. Back when your grandparents were working, they typically had a traditional pension, known as a defined benefit plan, where the employer was responsible for providing a specific amount of money to the employee upon retirement. With most pensions going away in the private sector, the duty of preparing for retirement has fallen on the employee more than it ever has been.

Not only are employees responsible for the amount they set aside in 401(k) plans, but they are also responsible for selecting the types of investments within their 401(k). Most employers’ 401(k) administrators will offer advice on what to select or to choose their basic cookie cutter allocation. This is the area you can make your 401(k) shine. If you are young, throw that cash into highly aggressive funds or stocks with low expense ratios.

Yes, it can be overwhelming… To not overwhelm you with the details, the best thing you can do is to look at your 401(k) available investments and compare the prior 5–10-year performance along with the expense ratios. At the end of the day, you will have to do a lot of research, but this research could be the difference of hundreds of thousands of dollars by the time your retire.

How Much Should You Contribute to Your 401(k) Plan?

Contribute up to the amount that your employer will match you. If your employer matches 5%, then contribute 5%. If your employer matches up to $5,000 then contribute $5,000.

The match from your employer is free money. I know some people emphasize putting as much as you can into your 401(k) but that’s not really the best route to take. Take your employer’s match then prioritize maxing out your IRA.

Traditional 401(k) vs. Roth 401(k)

The difference between traditional and Roth 401(k) plans is how they are taxed.

Traditional 401(k) plans are invested with pre-tax dollars. Traditional plans are usually the best option if you think you will be in a lower tax bracket by the time you retire. Since the investments are with pre-tax dollars, the funds are taxed upon withdrawal. Traditional plans also help if you are currently in a high tax bracket since they reduce your taxable income by the amount you contribute.

Roth 401(k) plans are invested with post-tax dollars. Roth plans are the best option if you believe you will be in a high tax bracket when you retire. By the time you retire and are withdrawing from your Roth 401(k), all the money will be untaxable. Roth accounts are usually the best for young professionals that are in a low tax bracket right now but plan to have a solid increase of salary over their life.

Taking Withdrawals from a 401(k) Plan

We are going to touch base on the early withdraw of 401(k) plans in this section. First, Roth 401(k) accounts may be withdrawn from UP TO the amount you contributed without incurring any penalties or taxes. If you withdraw from your Roth 401(k) before 59 ½ years old you may be subject to a 10% early withdrawal penalty if you withdraw above what you have already contributed.

For example, say you have contributed $10,000 into a Roth 401(k) and the balance is currently $12,000 due to capital gains and dividend reinvestments. You may withdraw $10,000 without penalty because that was funded with post-tax dollars. If you withdraw the entire $12,000 then you will incur a 10% early withdrawal penalty on the excess $2,000, resulting in a $200 fine.

Now, traditional 401(k)s are a different type of beast. The early withdrawal penalty is the same as Roth 401(k)s however since traditional plans are invested with pre-tax dollars, you will also need to pay tax on the amount withdrawn. Using the same example above, let’s say you withdrew $12,000 from your traditional 401(k). Not only will you be levied a 10% penalty on the entire $12,000, but the $12,000 will also be taxed at your ordinary rate.

Taxes, taxes, taxes. If you are contemplating withdrawing an amount from your 401(k), the best thing we at the Rules of Thumb blog from MoneyThumb can say is to do while you are in the lowest tax bracket and potentially have some juicy tax credits to save you a lot come April 15th.

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