The main benefit of 401(k) plans is that they allow retirement savings to grow tax deferred. But there are more advantages, especially in comparison to individual retirement accounts (IRAs). Read on for these less-known 401(k) benefits – plus for info about the newer Roth 401(k). Wish you were more retirement-ready? A financial advisor can help.
More people, including part-timers and those who work for small businesses, may soon have access to 401(k) plans than ever before. That is, if legislation that passed almost unanimously in the House, the Setting Every Community up for Retirement Enhancement (SECURE) Act of 2019, also passes in the Senate. Here’s what you need to know about the popular savings vehicle.
What Is a 401(k) Plan?
Named after the federal tax code section that created them, 401(k) plans are voluntary savings programs. Employers provide them and employees choose to participate in them. When employees do, a defined amount is taken out of their paychecks and sent directly to their 401(k) investment accounts. (Investment options often include mutual funds, exchange-traded funds and target-date funds.)
These contributions are pre-tax, which means they are deducted from your income before your income tax is calculated. Participation in 401(k)s has risen as pensions have become less common.
401(k) Tax Benefits
The tax benefits of 401(k)s are three-fold. First, as just explained, contributions are pre-tax. You don’t pay taxes on the money until you withdraw it when you retire. (At the earliest, this is age 59.5.)
Second, by not being counted as income, your contributions could put you in a lower tax bracket. The result: your tax bill will be smaller for your having socked away money for retirement.
Third, your savings grow tax deferred. In a regular investment account, your net gains and dividends would be taxed. But in a 401(k) plan, your money grows tax free as long as it stays in the plan. This allows your earnings to earn earnings – or as a financial advisor would say, to compound. You’ll owe taxes, of course, once you withdraw the money.
401(k) Company Match Benefits
Many employers offer to match employee contributions, either dollar for dollar or 50 cents to the dollar, up to a set limit. They do this to encourage people to sign up for the plan, which, as noted earlier, is voluntary. Company matches are also a good perk for attracting and retaining talent. (The IRS allows companies to set time periods of up to five years before matches are fully vested.) Whatever the reason a company has for offering a match, it is free money that you wouldn’t otherwise get. And like employee contributions, they are tax-deferred – and the earnings and the earnings’ earnings are tax-deferred.
401(k) Late-Saver Benefits
If you didn’t start saving for retirement the minute you started working full time, you’re hardly alone. Even if you waited until mid-career, you’ve got plenty of company. In fact, to help all of the late savers (or retirement deniers?) out there, the government allows annual catch-up contributions to 2020 401(k) plans of $6,500 by people who are age 50 or older. That’s in addition to the regular allowed employee contribution of up to $19,500. This is considerably more than the $6,000 annual contribution and $1,000 catch-up you can put in an IRA.
Additionally, if you are a super-late saver and want to continue working and contributing to your nest egg when you’re in your 70s, you can with a 401(k). This is not the case with a traditional IRA, though. By law, you have to stop contributing and start taking required minimum distributions (RMDs) at age 70.5.
401(k) Fiduciary Benefits
Because 401(k) plans fall under the Employee Retirement Income Security (ERISA) Act, employers have a responsibility to make sure that participants’ best interests are being put first. In other words, the plan administrators are held to fiduciary standard. This means that though costs don’t have to be the lowest available, they do have to be reasonable. Similarly, the investment options must be stable. Also, key information such as fees has to be clearly disclosed.
401(k) Emergency Benefits
Under normal circumstances, you have to pay a 10% 401(k) early-withdrawal penalty – on top of income taxes – if you withdraw money before age 59.5. But some employers allow participants to borrow money from their 401(k) account that they will have to pay back, plus interest.
It’s up to plan sponsors if they will allow loans and what the procedure for applying and the repayment terms are. The government only limits the maximum loan amount (half the vested amount in the account up to $50,000). It also caps the repayment time at five years.
IRAs, on the other hand, do not allow for loans. They do have penalty-free hardship withdrawals for such things health insurance after job loss, medical costs and first-time purchase of a home. 401(k) plan sponsors may allow for hardship withdrawals, too, but for them to be penalty-free, you generally have to meet strict requirements such as being disabled or having medical expenses that exceed 7.5% of your adjusted gross income.
Consider a Roth 401(k)
Some companies also offer Roth 401(k) plans. These are funded on a post-tax basis, so that contributing to one won’t reduce your taxable income. But the growth is tax-free – as opposed to tax deferred – so that when you make withdrawals once you reach age 59.5, you will owe no taxes on your contributions or earnings. (You will, however, owe taxes on your company match.) Also, you can make penalty-free withdrawals once you’ve had the account for at least five years.
Stowing savings in a 401(k) plan is a great way to prepare for your golden years. For one thing, because taxes are deferred until you retire, your earnings will compound – and grow faster than if you had to deduct taxes from the earnings. For another, companies often offer matches, which grow your nest egg even more. Additionally, 401(k) plans have benefits for late savers, individuals experiencing financial hardship and people who are not sophisticated investors and can use the screening and help of 401(k) plan administrators.
Tips on Managing a 401(k) Account
- Once you choose your investments from the menu of options, it’s easy to think you’re done (or want to be). But over time, you should be re-assessing your asset allocation (e.g., what percent is in equity and what is in fixed income) and rebalancing your assets accordingly.
- When you change jobs or retire, you may want to roll over your 401(k) to your new job’s plan or to an IRA. Doing this can be tricky, particularly if your account is large. But a financial advisor can help – and we can help you find one in your area with our free matching tool. After you answer a few simple questions, you’ll be connected with up to three suitable advisors.
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