Before deciding if a 401(k) is right for you, it is important to understand how the plan differs from a pension.
Pensions are benefit plans that guarantee a given amount of monthly income in retirement; the funding investment and longevity risk are assumed by the retiree’s employer. In the 1980s, many employers replaced pensions with 401(k)s, which were created by the Revenue Act of 1978. A provision was added to the Internal Revenue Code to allow employees to avoid being taxed on deferred compensation.
Named for the sections of the IRS tax code that govern it, this is a contribution retirement plan, which is sponsored by an employer. However, the employee participant is responsible for funding and investing the money, and there is no guarantee of a minimum or maximum benefit. Today, 401(k) Plans comprise the largest amount of retirement assets for most retirees.
Key features of 401(k) Plans:
Eligibility and enrollment
An employee becomes eligible on the anniversary date of their hire or after completion of a probationary period. Pending retirement, the employee may initiate their contributions by either completing required forms or by making a phone call to the issuer of the fund.
Contributions
This year an employee may contribute $19,500 to a 401(k) Plan. If the individual is over age 50, an additional $6,500 contribution is allowed. A vital decision to make is which type of contribution, Traditional or Roth, is best for the employee’s circumstances.
Traditional contributions have been the norm in 401(k) Plans since 1978. Roth 401k contributions made their debut in 2006. Traditional contributions are deducted from paychecks prior to taxes. When the employee retires and begins taking income from their traditional retirement account, that income is then taxed. With Roth contributions, the employee pays tax now. When they take the funds out, upon retirement, this money is tax free. In either case, the funds are taxed-deferred while held in the 401(k) Plan.
Frequently, employers set up a match in their 401(k) Plan. To receive the match, in most cases an employee must contribute, too. If a company provides a 3% match for the employee, then the employee should contribute 3%, as well. If they put aside less, they lose the full available amount of matching funds.
Be aware that contributions are diversified among funds offered in a plan. On average, a 401(k) Plan has a variety of funds available Target Date funds, which are professionally managed by well-known companies, such as Vanguard, American Funds and Fidelity. These and many other firms offer a full range of fund options, ranging from conservative bonds to riskier internationals. Why the choices? Numerous investors are all willing to take on some form of risk to see funds grow; yet, not everyone has similar risk tolerance.
Tax deferral /compounding growth
The power of tax deferral and compound growth in a 401(k) allows the employee to save even more money for retirement. Money they put in their 401(k) plan is deducted from their paycheck. That money is diversified in funds they have selected, and all earnings on these funds are free from taxes each year they remain in the 401(k) plan. In short, the money they would have paid in taxes on any earning stays in the plan to earn even more toward retirement. Most remove their money gradually, only paying taxes on what they take from the fund. Roth contributions, however, are the exception. All Roth funds come out tax free, because taxes are deducted from the employee’s pay when they contribute.
Access to the money while employed — loans or withdrawals
Loans allow an employee to take money out of their 401(k) Plan. As long as the fund includes the minimum amount required, a loan may be requested. Because it is a loan, no taxes are due when activated. Charges or interest for borrowing the money go back into their own 401(k) account. The employee repays the loan through paycheck deductions. If an employee takes out a loan prior to age 59½, there is also a 10% federal penalty. A few exceptions to this rule are disability or death, which waive the penalty.
Withdrawals may also be available in an employee 401(k) Plan. The difference is that withdrawals are never paid back, but they are taxable to the employee.
Portability
There are a few options when it comes to portability with 401(k) Plan funds. When an employee leaves a company, they may choose to take their 401(k) Plan with them. If there is more than $5,000 in the plan, the departing employee may keep it in the existing plan. If there is less than $1,000 in the plan, a check may be issued for the amount. Additionally, if there is less than $5,000, an IRA may be set up.
Another option is rolling it the funds over to an IRA. Numerous financial planners believe value is added by rolling over 401(k) funds to an IRA. An investment team selects funds based on an individual’s risk tolerance, coupled with their goals.
If you’re considering a 401(k) as a retirement income option, discuss your goals with a financial planner or accountant. There is pending legislation concerning contributions, benefits and credits.
Pete Hoover was destined to be a financial advisor. He has always been intrigued by numbers and money matters. They represent captivating puzzles to be analyzed, shaped and fit into place as pictures of financial solidarity. For nearly 40 years, Hoover has tackled those financial puzzles. In 2005, he launched Hoover Financial Advisors, located in Malvern. Hoover can be reached by emailing pete@hfaplanning.