Your employer must follow certain rules to be able to offer a 401(k). The Employee Benefits Security Administration, part of the Department of Labor, regulates these plans and spells out the rules.
What Is a 401(k) Plan?
A 401(k) plan is a special type of account funded through payroll deductions that are made before taxes are paid on the balance. The funds in the account can be put into various investments, usually mutual funds. They’re not taxed on any capital gains, dividends, or interest until the earnings are withdrawn.
Tax Benefits and Pre-Tax Contributions
Employers first began offering 401(k) plans when Congress passed the Revenue Act of 1978. You normally have income taxes withheld from the money you earn as a worker. A 401(k) plan allows you to avoid paying income taxes in the current year on the amount of money that you put into the plan, up to the 401(k) contribution limit. The amount you put in is called a “salary deferral contribution,” because you’ve chosen to defer some of the salary you earn to put it into the plan. You can save this money so you can spend it in your retirement years. The money grows tax-deferred inside the plan. You only pay tax on the amounts when you withdraw the money in retirement. You’ll pay a 10% penalty tax and income taxes if you withdraw funds too early—before age 55 or 59 1/2. The age limit depends on your 401(k) plan’s rules. The most you can invest in your 401(k) account depends on your plan, your salary, and government guidelines. The IRS sets your annual salary-deferral limit. This limit is $20,500 in 2022 and $22,500 in 2023. You can contribute additional amounts if you’re age 50 or older if your employer offers these “catch-up” contributions. These limits are an additional $6,500 in 2022 and $7,500 in 2023.
A Tax Savings Example
Assume you make $50,000 per year. You decide to put $2,500 a year into your 401(k) plan. You’ll have $104.17 taken out of each paycheck before taxes have been applied if you get paid twice a month. This money goes into your plan. The earned income you report on your tax return at the end of the year will be $47,500 instead of $50,000 because you get to reduce your earned income by the amount you put into your plan. The $2,500 you put into the plan means $625 less in federal taxes paid if you’re in the 25% tax bracket. Saving $2,500 for retirement, therefore, only costs you $1,875 because you saved $625 on taxes.
Roth 401(k) Contributions
Many employers also offer Roth 401(k) plans. You don’t get to reduce your earned income by your contribution amount with these plans, but all funds grow tax-free. You can also take all of your withdrawals tax-free.
Pre-Tax or After-Tax?
It’s often best to make pre-tax contributions to your 401(k) plan in the years when you earn the most. This might be the middle and late stages of your career. Make your Roth contributions using after-tax dollars during years when your earnings and tax rate aren’t as high. These years often occur during the early stages of a career or during a phased retirement when you work part-time.
Employer Contributions
Many employers will make contributions to your 401(k) plan for you. Three types of employer contributions include matching, non-elective, and profit-sharing. Employer contributions are always pre-tax, so these will be taxed when you take the money out.
Matching Contributions
Your employer only puts money into the plan if you do so. Each employer’s contribution amounts may vary. For example, a company may match your contributions dollar for dollar up to the first 3% of your pay, then 50 cents on the dollar up to the next 2% of your pay. Another company may pay 100% up to 8% of your pay. In the first scenario, say you paid into your 401(k) 5% of your $50,000 salary, or $2,500 a year. It would match the first 3% of your pay, or $1,500, by putting in $1,500. It would match 50 cents, or $500, on the next 2% of your pay, or $1,000. Its total contribution on your behalf would then be $2,000 for the year.
Non-Elective Contributions
Your employer may decide to put a set percentage into the plan for all workers, regardless of whether you’re putting in any of their own money. For example, an employer can contribute 3% of pay to the plan each year for all eligible employees.
Profit-Sharing Contributions
The company may elect to put a set dollar amount into the plan if it makes a profit. Different formulas determine how much can go to which workers. The most common formula is that all workers receive an amount proportional to their pay.
When Is the Money Yours?
Some types of matching employer contributions are subject to a vesting schedule. The money is there in your account, but you may not get any of that money if you leave your job before you’re 100% vested. Some companies might offer graduated vesting, which means your employer’s contributions vest at increasing percentages based on how long you’re employed. For example, after one year, you’re 50% vested. After year two, you’re 75% vested, and then you’re fully vested after three years. That being said, you get to keep any of the money that you personally put into the plan.
Discrimination Rules
Employers can’t set up 401(k) plans just to benefit themselves or their highly paid employees. A plan must go through a test each year to make sure it meets these rules, or the employer can set up a special plan called a “safe harbor 401(k) plan," which allows them to bypass the testing process. Its 401(k) plan will “pass” any of the tests as long as it puts in a legally required amount, either as a match or as a non-elective contribution. Any matching or non-elective contributions the employer puts in for you are vested right away with a safe harbor plan.
Investment Choices
Most 401(k) plans offer at least three investment options. Many plans set up a default option, such as a certain mutual fund. All money goes there unless and until you log in online or call your plan administrator to change it.
Options for Beginners
Many 401(k) plans offer target-date funds based on a particular year in the future that matches the one when you think you may retire. These can be great options for new investors. Some 401(k) plans also offer model portfolios. You’ll fill out a questionnaire, and options then will be recommended to you. You might be best off using a target-date fund or a model portfolio unless you’re a savvy investor or you’re working with a financial planner to advise you. These default options are often foolproof ways to invest.
