Tuesday, October 19, 2021

401(k) Plans Explained- Basics, Advanced And Everything In Between

For a hassle-free retirement.

While planning for post-retirement life, it is imperative to know everything about a 401k plan. It’s never too late or too early to begun planning for the later years of your life. One of the biggest mistakes that the majority of Americans commit during retirement planning is starting late. According to a report by Morning Consult, just 39% of American adults started saving for retirement in their 20s. Further, half of the adults between 18 and 34 years of age are not at all saving for retirement.

This is where the awareness about the plan comes into the picture. Almost two-thirds of Americans are confused about the 401(k) plan– what is it, how to begin with the procedure, and what next.

Here we have attempted to solve all the confusions that people face with their retirement planning, especially the 401(k) plan.

What is the 401(k) Plan?

A 401(k) is a retirement savings plan sponsored by employers. It is a tool for workers to save and invest a part of their salary and comes with added tax advantages. Taxes under 401(k) are not deducted until the employee decided to withdraw the amount.

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It is governed by The Employee Benefits Security Administration of the Department of Labor that largely oversees the private sector pension plans. Under this plan, the employer and the employee make a combined contribution.

There are two basic types of 401(k)s—traditional and Roth – and primarily differ in the manner in which they’re taxed.

How does it work?

Employees are able to control how their money is invested by opting for a 401(k). Most of the plans offer employees a range of mutual funds that are composed of stocks, bonds, and money market investments. It is argued that the most popular option tends to be target-date funds – a combination of stocks and bonds that tend to become more conservative as one reaches retirement.

However, to understand how does the 401(K) plan works, it is first important to understand the types of plans-

What are the different types of 401(k) plans?

There are majorly 5 different plans offered 401(k) – Traditional, Safe harbor, Simple, Solo, and Roth 401(k) plans,

Traditional plan under this type of plan, the amount is deducted out of the employee’s gross income which reduces the taxable wages, likely resulting in less federal income, social security, and Medicare taxes.

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Safe harbor 401(k) plans– this plan is almost similar to the traditional 401(k) plan except for one fact- it does not require the plan holder to go through complex annual nondiscrimination tests that are mandatory for the traditional plan.

Simple plan– is a simplified version of a traditional 401(k) plan and suitable for small business owners or self-employed professionals with 100 or fewer employees. It is a combination of features of a traditional plan and the simplicity of a Simple plan. The contributions made by an employer under this plan become non-forfeitable as soon as one contributes them.

Solo plans– called Solo because it has only one participant and is a form of a Traditional plan and specifically designed for a business owner or self-employed individual who has no employees apart from their spouse or business partners. An employer can make contributions both as an employer and an employee which allows small business owners to maximize retirement contributions and business deductions.

Roth 401(k) plans– under this plan, the amount is deducted after the taxes are deducted on income. This allows withholding taxes from an employee’s gross pay before their wages are deferred to the 401(k) plan. Unlike the Traditional 401(k), withdrawals after retirement from a Roth 401(k) account are tax-free.  

What are its benefits?

Opting for this retirement plan can bring in a number of benefits for employees that include:

  • Opportunity to improve post-retirement financial security
  • Opportunity to avail a loan on saved money
  • Current taxable income can be reduced by the contributions
  • No taxes on contributions and investment gains until those are withdrawn
  • Provides compounding interest which, over time, can make small and regular contributions grow to significant savings on retirement
  • Easily carried from one employer to another
  • Retirement assets can be carried from one employer to another.

401(k) withdrawals in 2021

To be eligible for withdrawals under the 401(k) plan, an employee must be at least age 59½ years old or meet other criteria as specified by the IRS under the Traditional and Roth 401(k) plans.

Apart from the age criteria, there are certain triggering events that by default allow the withdrawal-

  1. Retirement from job
  2. Death or disability of employee
  3. Specific hardship as defined under plan.
  4. Termination of plan.

If none of the above conditions are met, 410(k) withdrawals usually face an additional 10 percent early-distribution penalty tax in addition to any other applicable tax.

However, the above-mentioned rule has been suspended for 2020 and 2021 for those employees affected by the COVID-19 pandemic.

It is possible to access money from a 401(k) through hardship withdrawals for reasons like medical care, college tuition, and funeral expenses.

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For loans against money contributed in a 401(k) plan, the cap is usually at 50 percent of the vested balance, up to $50,000 in total. One has to pay back any outstanding balance against a loan by the next tax filing deadline in case of leaving a job, else the loan may become taxable and subject to the 10 percent penalty.

Traditional 401(k) vs. Roth IRS

In a Traditional 401(k) plan, an employee pays the taxes on contributions and earnings only when the savings are withdrawn while under the Roth IRS 401(k) plan, employee contributions are not tax-deferred but are made with after-tax dollars. There is no tax on the income earned on the account, from interest, dividends, or capital gains.

Is it worth investing in 401(k)?

This plan can be a very useful tool for employees to save money while they are in employment. However, the decision to participate in a 401(k) plan depends on the current cash-in-hand requirement of an employee and their choice of retirement plans.

It is are suitable for those employees willing to forego a part of their current wages for post-retirement security. Further, the plans can be really financially useful for employees if their employer also makes a matching contribution. 401(k) plan also can help to reduce the immediate federal tax burden.

How do you get your 401(k)?

Typically both an employer and an employee can opt to go for a plan. An employee can avail it to save money for retirement while an employer can use a 401(k) plan to attract talent with matching contributions.  

Conclusion

401(k) plan can be a great way for employees of any age to save money for retirement while also using it as a tool for saving on current tax burdens. Multiple 401(k) plans are available for employees to choose from. It can be most useful as a financial tool when employers make a contribution as a means of providing additional financial benefits for employees or attracting talent. 

Debdutta Ghosh
Debdutta Ghosh is a Journalist who has been associated with leading media firms of India like Asian Age, Indian Express and Hindustan Times as well as television channels such as Zee News/Business and ABP News as a reporter for more than 20 years. With a Post-Graduation Diploma in Mass Communication & a Bachelor Degree in Science, his expertise as content expert lies in the areas of Business News Analysis, PR, and Marketing Communication.

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