Why would you choose a 401(k) plan?
Did this ever occur to you?
Among all the retirement plans and saving schemes available, why would you choose to go with a 401(k)?
401(k) contributions are directly deducted from your paycheck. So, it's hassle-free. The gains are tax-free as well. You can lower your tax liability while investing for retirement with a 401(k) plan.
However, the best part is, that a lot of employers match a portion of their employees' 401(k) contributions, giving a big boost to their employees' retirement savings.
The concept of retirement is centuries old – it’s almost 2 centuries now! Back in 1905, the German Chancellor, Otto Van Bismarck forced citizens aged over 65 to retire. The Social Security Act 1935 was introduced by Franklin D Roosevelt in the U.S post the Great Depression.
Not that these were the very first instances of a social retirement program. Soldiers in the historic Roman empire were provided with a pension!
401(k) at a glance
The 401(k) plan allows qualified employees of a company to invest and save for their retirement while deferring taxes.
The only sponsor that your 401k plan can have is your employer.
You get to choose the amount you want to have withheld from your pay and placed it into the plan.
The amount is, however, subject to restrictions imposed by the plan's requirements and the IRS regulations too. Making contributions to your plan is optional for your employer.
Your employer, on the flip side, is responsible for the plan’s continuation in compliance with the law, rules and regulations, and the terms of the plan itself.
How much should you contribute to your 401(k) account?
The maximum 401(k) contribution in 2022 for individuals is $20,500. If you are aged 50 or older, it’s $27,000. Now, coming to how much you should decide to pay out from your paycheck.
At the very least, do put as much money into your 401(k) as your employer agrees to match. However, if you're able to save even more, you may contribute up to $20,500 (or $27,000 if you are above 50) in 2022.
Wait! Before investing all that money in your 401(k), you need to think about certain things.
Take the advantage of your employer’s matching contributions. For instance, your employer agrees to contribute an amount that’s 6% of your salary. Try contributing the least amount. If you’re not doing that, you are doing something like consenting to a pay decrease! You are giving up an amount of money that you were entitled to!
What happens to a 401(k) when you need to quit?
Suppose, you need to terminate the contributions that you are making to the 401(k) for a certain while (to handle some crisis). In such a case you can't receive those salary matches back by making more contributions in the end (during the last few pay periods).
Now, for instance, say, you defer a considerable part of your paycheck in the earlier part of the year to max out contributions; you would not receive the matching contributions later in the year!
What happens to 401(k) when you leave your job?
While it might be tempting to withdraw all the money, your fiduciary financial advisor would certainly advise you against cashing out the 401(k) money.
You have 3 good options at hand, once you've made the decision not to cash out your 401(k). Moreover, you neither have to pay income tax nor incur an early withdrawal penalty.
Leave the money in your former 401(k) plan
Transfer it to an IRA
Transfer the remaining funds to your new employer's 401(k).
To choose which would offer the best investment opportunity it would be a good idea to evaluate the three options.
Generally speaking, 401(k) plans only give a small selection of investment possibilities, whereas IRAs provide a far wider range of options. A lot of 401(k)s have subpar investments and astronomically high fees; it’s therefore, wiser to transfer the funds to another account.
Talking about how to roll over 401(k) to IRA, it is significantly easier to have the account balance sent directly to the trustee of the new plan, as no tax would be deducted in this scenario. To avoid tax implications, you might want to electronically move money from your 401(k) to your IRA.
Let us now compare some of the retirement schemes that are popular these days.
Traditional 401(k) vs. Roth 401(k)
Both standard and Roth 401(k) accounts are options, just as the 2 forms of individual retirement accounts (IRAs) – traditional and Roth. The yearly employee and employer contribution limitations are identical for both types.
The Standard 401(k)
With a typical 401(k), you are allowed to annually deduct the total of your employee contributions from your taxable income. The remaining amount is taxed only! This means that if you earned $60,000 and made $6,000 in standard 401(k) contributions, your taxable income would be $54,000 instead of $60,000.
This certainly implies that the withdrawals would be subjected to taxes. Based on your marginal tax rate at the time of taking out your money (after retirement or at age 59 ½), the amounts would be taxed.
401(k) contributions are made with money that has already been taxed. As long as five years have passed since your first deposit, withdrawals made beyond age 59 ½ are tax-free. There are a few shortcomings; consider them before you go for one -
Roth 401(k)s aren't offered by all employers, though this is changing quickly.
You cannot save a 401(k) match offered by your employer in a Roth account. A standard 401(k) plan is used to save employer matching payments.
Unlike Roth IRAs, Roth 401(k)s don't have an income cap, so anyone with access to one can make contributions.
So, which is better? Which one to go for?
Tax pays create the primary distinction between a regular and a Roth 401(k). You receive a tax break straight when you contribute to a standard 401(k). So you are paying fewer taxes as far as your current income is concerned.
Until you withdraw the amounts - both contributions and earnings – they grow tax-deferred. Later on, withdrawals are treated as ordinary income and you need to pay Uncle Sam at the current tax rate then!
In a Roth 401(k), it basically works the other way around. You are saved from tax deductions as the contributions are purely made with after-tax money. Withdrawals, therefore, are normally tax-free.
So, while considering “which is better” you need to first decide when to pay your taxes - now or later. A lot of that depends on the time-frame and what rules and regulations are entailed in the future.
The Roth 401(k) might be a wise decision if you're young and certain that you'll be making more money and falling into a higher tax rate in the future!
Is it OK to have both 401(k) and Roth IRA at the same time?
A 401(k) and a Roth IRA can both be held simultaneously. Not only is it legal, but contributing to both might be a smart way to save for retirement.
Contributing to both a 401(k) and a Roth IRA can offer tax benefits in the short- and long-term if you are eligible to do so.
These accounts help increase your retirement nest egg. Sooner or later in your life, you’ll come to terms with this fact.
You can both maximize your retirement savings and enjoy the tax benefits by making contributions to both accounts.
You can donate money that hasn't yet been taxed to a 401(k) account. Depending on your annual income, your company might also match your contributions up to a particular amount.
The qualifying distributions or withdrawals, in case of a Roth IRA, are not taxed. So, you can stack your tax advantages while investing for retirement by combining these accounts!
Are there any withdrawal rules for the Roth 401(k)?
More or less, we live in a world that's composed of Roth IRAs. The population of the Roth 401(k) has just started to heighten.
In the case of Roth accounts, the 401(k) is less popular than the IRA variant. The contours of the withdrawal rules for a Roth IRA are, therefore, better defined than that of the Roth 401(k).
However, if you are holding a 401(k), and not a Roth IRA at the moment, you need to know the consequences of an early 401(k) withdrawal too.
Emergencies make you tap into funds reserved for a secured future. Every American knows the basics of how a 401(k) works. What if you need to withdraw some amount from it? Take a look at both the ‘withdrawal’ rules and the ‘exemptions’ (that allow you to avert the penalties) too!
1. IRS penalizes 10% of any amount withdrawn before the age of 59½;
2. Any amount that’s withdrawn before 5 years (from the commencement of the account) would be taxed!
3. Penalty-free withdrawals are offered under certain circumstances like:
First-time buying of a home (withdrawal up to $10,000 is allowed)
For QHEE (Qualified Higher Education) that includes tuition fees, costs of books, etc.
Medical expenses and/or if the court obligates payment of funds to sustain dependents, children, or a divorced spouse.
4. Rule Of 55 offers penalty-free withdrawal in case of a job loss faced between ages 55 - 59½.
5. The SEPP (Substantially Equal Periodic Payment) allows yearly withdrawals without being penalized. Funds are taken out under 72(t) distributions. You only have to continue taking the yearly payments once it starts for 5 years or until attaining the age of 59 ½ (whichever is longer).
The biggest downside to an early withdrawal is losing future market returns. Act wise and make financial decisions after discussing all available options with the best Los Angeles financial advisor.
This vivid account of the investment plan 401(k) and its variants will hopefully guide you through your retirement decisions and/or investment plans.
So, happy investing!