What is a 401 K Plan ? How does it work And Should I withdraw from my 401 k?

Retirement savings are taking a new turn in recent times compared to the traditional pension system. Through the 401(k) income earners or employees have a well-structured and more diversified retirement plan. Most employers make use of the 401(k) retirement plan for their employees. You may have learned about the IRA retirement plan—there are quite a few similarities between the IRA and 401(k) retirement plans yet both plans have certain factors that differentiate them. In this article, we shall be considering fundamentals of the 401(k)—how it works, why it’s important, contribution limits, and other important details to capture.

What is a 401(k)?

One of the first things to note about the 401(k) is that it is not a type of investment, rather, it is a type of account with tax advantages that supports investments such as mutual funds, stocks, ETFs, etc. In simple terms, a 401(k) is a type of account similar to a savings account created for the purpose of saving for retirement. The process involves taking out a percentage of your total generated income yearly and funding your retirement account over the next couple of years. You get access to the funds when the estimated time is due, but make withdrawals in bits. 

“A 401(k) retirement plan is a special type of account funded through pre-tax payroll deductions. The funds in the account can be invested in a number of different stocks, bonds, mutual funds, or other assets, and are not taxed on any capital gains, dividends, or interests until they are withdrawn.”

Advantages of Having a 401(k) Account

• Tax advantages

• Available investment options

• Employer matches

• Access to loans and hardship withdrawals

• Transfer of 401(k) account to another employer

How is a 401(k) Plan Better Than a Savings Account?

Rather than just having a regular savings account, using a 401(k) offers certain benefits and tax-advantages. It helps you defer your income until a later time—any money that goes into a 401(k) plan has no taxes attached to it, thereby, lowering your yearly taxes. For example, a person who earns $60,000 per year is expected to pay federal income taxes on the $60,000 income. If that person contributes an annual $6,000 (assuming it’s a single) to his/her 401(k), the taxable income would automatically exclude the 401(k) contribution. Thereby making the new taxable income $54,000 instead of $60,000. On the flip side, all deferred taxes will be recovered at the point of distribution. The good part is that the taxes will still be lower than what you would pay now since the total retirement savings would be far less than your earnings over the working years.

The advantage 401(k) or retirement accounts have over regular savings account is mostly in the area of taxes. A savings account may attract interests, but you’d still have to pay taxes on the interests. Another advantage a 401(k) has over a savings account is in the aspect of diversification—as in you get to choose what investment vehicles such as stocks or real estate you would like the company to put your contributions into or just simply leave your money in your contribution account and earn yearly interests on it. The purpose of choosing an investment option is to generate even greater income, however, this does not guarantee a risk-free investment. It is best to know the requirements and risks involved before permitting your retirement savings to be used for investments.

Building Your 401(k)

Building a 401(k) plan requires that you devise viable investment strategies. You can begin building your retirement account by starting early; just in case you’ve spent a good part of your working years already, not to worry it’s never too late to start.  It would be really nice to save greater amounts of money especially if you have big dreams for retirement, however, if that’s not available, start with whatever you have. It’s better to make a 1% contribution of your income than not to contribute at all, nevertheless, it would be totally unwise not to aim for a 10% contribution as the years go by. Another wise thing to do when building your 401 (k) retirement account, it is a lot safer to save according to your employer’s match. Though the total retirement savings amount usually doesn’t match the overall generated income—that is, from your working years, it is still possible to amass great wealth that can match your overall working income. How? Through making the right investments and contributing high amounts to your retirement account. (Note that there is a fixed contribution amount for all contributors. We would discuss that later).

Do NOT Make Early Withdrawals from Your 401 (k) Plan

Now, a few financial difficulties or pressing demand for money may come up from time to time (hardship withdrawal). The last place to take out money from should be your retirement account. There is a 10% early withdrawal charge for contributors under age 59 ½, but that’s beside the point. Taking funds out of your retirement account not only attracts outstanding taxes but would also affect your retirement plan by cutting short the expected total contribution. It also has a way of affecting the building of your 401(k) plan. Let’s say you borrow $10,000 from your retirement account you would have to repay the money alongside still making your yearly contributions. The implication of this is that your finances may suffer unless you decide to commit to repaying the amount and lowering your yearly contribution. There are some permissible reasons to take from your retirement account; reasons such as buying your first home, getting an education, or doing something that stands as a good self-investment. 

Maximum Contribution Limits for 401(k)

The 401(k) maximum contribution limit has an annual fixed amount, but can still be determined by an employer. An employer can determine the employee’s maximum contribution limits by considering certain employment factors such as salary, government guidelines, and any other specific detail. Since employees do not have direct access to determining contribution limits except through their employers, they have no choice but to match that limit. For example, an employer may choose 4% or 3% of total pre-tax income as a contribution limit due to the nature of the job. Other employers may permit a 10% contribution. The government guideline for maximum contribution limit for 2020 is $19,500 and is subject to increasing by an additional $500 over the next few years.  Over the past five years, the general maximum contribution limit has steadily increased by $500. Employees who are above 50 are allowed to contribute extra amounts on their regular contributions that way they still get to meet their savings target before retirement. This is called ‘catch up contributions’. The catch-up contribution for 2020 is $6,500.

Why is the Employer Match Important in a 401(k)?

In a 401(k) plan, employers also make contributions to employee’s retirement account though the contributions would not be yours 100% until certain demands have been met. The personal contributions and investment gains you make in your account are completely yours, but to gain full ownership of your employer’s contribution you have to be qualified for it. Employers usually draw up an outline indicating when the company’s contribution in your retirement account would fully be yours—this is called a vesting schedule. Most employers/companies would require that you work for a particular period of time before gaining full ownership of the company’s contributions to your account (100%). For example, an employer or company can decide to match a certain percentage to the first 5 percent of pay/income the employee contributes to his/her 401(k) account. So, an employee, who earns $60,000 makes a contribution of $4000 would receive an additional contribution of $4000 by the company or employer after the agreed period of time stated in the vesting schedule. Think of an employer match as getting free money from your company.

What is the Difference Between 401(k), 403(b), and 457 (b)?

There’s nothing technical or special about these titles they are all similar. The only major difference is the type of employer involved. The 401(k) plan is reserved for-profit companies while the 403(b) is used by non-profit companies. On the other hand, the 457(b) is reserved for governmental agencies. That’s about the differences. As regards the titles, they are referred to as such because they represent the specific laws that govern them. For example, the 401(k) is simply a law describing a plan in chapter 401 and section (k) of the Internal Revenue Code book. The same applies to the 403(b) and 457(b) plans.

Borrowing from 401(k)

In as much as the last place, you should consider taking money from is your retirement plan before the due time. However, it is still understandable that financial emergencies tend to rise from time to time. A 401(k) plan can both be considered as a retirement plan and emergency funds saving that is why most 401(k)’s allow owners to borrow money from their accounts in the case of a financial emergency. Loans taken are repaid to the account with interest. It seems easier than it looks because it also comes with implications such as cash shortage and failure to repay 401(k) loans will cause the retirement account to suffer greatly.

Rules

• Account-holders are allowed to borrow only 50% of their vested account balance or at most $50,000. 

• Account-holders can borrow up to $10,000 if their retirement plan allows it. This is usually for vested account balance below $10,000

• All loans must be repaid within five years

The general borrowing rules are applicable to all, but employers still have the liberty to set additional borrowing rules for employees. An employer can decide to set a limit on the number of times an employee can borrow from their retirement account yearly or set a custom borrowing maximum the employees can access. Borrowing money from your retirement account is a way to have an early withdrawal without incurring penalties. There should be no rush when borrowing money from your retirement account, so as to avoid future regrets. Future regrets can be avoided by first putting certain facts into consideration before taking out from your 401(k). You may want to carefully access your current and long-term financial stability, review the interest rates available on the amount you want, and means of paying back the money without suffering a financial shortage. Since the loan repayment takes five years, you may want to consider the implications of leaving an employer before you fully repay the loan.

401(k) Rollover

A 401(k) rollover basically has to do with transferring the money in current your retirement account into a new account or IRA. When rolling over a retirement plan, the owner is usually given 60 days to complete the process. Failure to meet up to the 60-day plan would attract a 12-month waiting period before another attempt.

Peradventure, you don’t know what to do with your existing 401(k) plan after leaving your employer, you may want to consider a rollover. Typically, you are provided with two options—to either leave your money in your 401(k) account or rollover your account to a Roth IRA. Leaving your money in a 401(k) keeps your money away from creditors and gives you access to taking a loan. While a rollover provides you with a more diversified investment selection to choose from compared to an average 401(k) that lets you select from only nineteen investment options. It also offers cheaper investments as the cost comparison is dependent on your employer’s investment offerings, and lower account fees as IRA charges no account fees, unlike 401(k) which often send account management fees to employers.

 Both options have their perks, but the idea of having a retirement account is to save and make profit. Take note of the fact that it is not compulsory to convert your 401(k) to an IRA plan. If you strongly feel the conversion is best for you then here’s how to go about it.

• Carefully consider where you want to roll over to. It could either be a bank or a brokerage.

• Choose the type of IRA you would want your money rolled into, and the investment options you would like to consider

• Research selected firms that fit your requirements and would like to open an account with (only select one)

• Find out other things involved in rolling over before proceeding. E.g., a direct rollover allows your directly transfer your money from your 401(k) to your IRA account without having direct contact with the money.

• Consult with a tax professional about your rollover intent to ensure that you are on the right path.

You may also want to employ the services of a broker or Robo-advisor to help you sort out the best investment options that match your profile/portfolio.

Other interesting facts about the 401(k) plan

No contribution age limits: Unlike the IRA retirement plan which stops contributions on a particular account once the owner turns 70 ½, the 401(k) plan allows owners to keep contributing till whatever age so long as they remain employed. A person is no longer eligible for a 401(k) contribution on retirement. 

Not all employers offer a match: Employers match is a useful tool in 401(k) in the encouragement of employees, however, not all employers offer their employees this opportunity. Some employers do not offer a match for certain reasons which mostly revolves around the financial implication. So, do not get upset when your new employer doesn’t offer a match, whereas, your former employer did. The few companies that offer a match still differ in the match percentages.

Limited investment options: In as much as the 401(k) supports investments and diversification the owner is still limited to investment options offered by the 401(k) management firm contracted by the employer. The average investment options offered by most retirement management firms are 19 which is below par compared to a large number of available tradable equities. There are over 6,500 tradable equities in the world today.

Permissible early withdrawal: It has been earlier established that early withdrawal or taking out from your retirement account attracts a 10% penalty and other implications. However, there are a few permissible reasons that allow for early withdrawal. The reasons are as follows:

• Using the separation from service rule, owners are able to access funds in their retirement account at an early age.

• Unpaid medical expenses

• Suffering a long-time injury or getting permanently disabled

• Called to active duty as a qualified military reservist

Conclusion

The 401(k) plan is a very useful tool for retirement savings offered by workplaces. The benefit of having a working retirement plan or pension plan on time is having enough money saved up by retirement. Some folks never get to be millionaires during their working years until retirement. On the contrary, not having a retirement plan could result in social security dependency when you retire. The money received from social security is nothing compared to what you can get at the end of a good retirement plan.